Author: Arunkumar Krishnakumar, CoinTelegraph; Translated by: Tao Zhu, Golden Finance
1. Federal Reserve Interest Rates and Cryptocurrencies
Interest rate changes affect cryptocurrency prices through changes in investor behavior and market dynamics.
The Federal Reserve, or the Fed for short, acts as the central bank for the United States. One of its primary responsibilities is to manage the nation's interest rates, which essentially controls the cost of borrowing. Lower interest rates make borrowing cheaper, increase liquidity in the economy, and stimulate consumer spending and investment. Conversely, higher interest rates discourage borrowing, reduce the amount of money flowing within the economy, and slow economic growth, thereby curbing inflation.
Asset prices, including stocks, bonds and even cryptocurrencies, tend to be inversely related to interest rates. As a rule of thumb, interest rates can be thought of as the common denominator used in asset pricing. If the value of that denominator increases, the price of most assets will fall, and vice versa. Therefore, highly volatile assets such as cryptocurrencies and non-fungible tokens (NFTs) are no exception.
From a behavioral perspective, when interest rates are low, banks offer lower interest rates on savings. As a result, investors are more likely to seek out riskier assets such as venture capital and cryptocurrencies in pursuit of higher returns. This increase in demand could push the price of the cryptocurrency higher. On the other hand, rising interest rates make safe-haven assets like savings accounts and bonds more attractive, pulling investment away from riskier ventures like cryptocurrencies and potentially causing prices to fall.
The impact of interest rates is particularly pronounced for riskier assets. Cryptocurrencies are particularly sensitive to changes in the interest rate environment due to their inherent volatility and lack of established financial history. The historical price action of the cryptocurrency market proves this. As cryptocurrency prices plummet and liquidity leaves decentralized finance (DeFi) protocols, the blockchain ecosystem is starting to look like a ghost town without many users or transactions.
2. The relationship between interest rates and cryptocurrency prices
While not always direct, historical trends highlight the impact interest rates have on Bitcoin price dynamics, with cascading effects across the broader cryptocurrency, NFT and DeFi markets.
Bitcoin (BTC), the largest cryptocurrency by market cap, has a complex relationship with the Federal Reserve’s interest rate decisions. While the correlation isn’t always perfect, historical trends paint a clear picture. The impact of interest rates on Bitcoin’s price has a ripple effect on the cryptocurrency, NFT, and DeFi markets.
Back to 2018
Under then-Chair Janet Yellen, the Fed began a series of rate hikes aimed at easing inflation concerns. This period coincided with a significant decline in the price of Bitcoin. Bitcoin went from peaking near $20,000 in December 2017 to plummeting to around $3,200 in December 2018, a staggering drop of more than 80%.
As the price of Bitcoin fell, so did the entire cryptocurrency asset class. While other factors such as exchange hacks and regulatory uncertainty also played a role, the rising interest rate environment was undoubtedly the main cause of this crypto winter.
Fast forward to 2021
Bitcoin surged to an all-time high of over $68,000 in November 2021, boosted by ultra-low interest rates implemented by the Federal Reserve during the pandemic. Excitement is at its peak as multiple experts call for Bitcoin to hit $100,000.
However, the Fed's stance on interest rates and broader monetary policy began to shift toward the end of 2021. With inflation concerns resurfacing, the Federal Reserve has signaled its intention to raise interest rates and reduce liquidity within the economy. This hawkish shift triggered a sharp correction in the cryptocurrency market over the next few months. By June 2022, Bitcoin’s value had fallen by more than 70%, falling below $20,000 again.
The chart above shows the evolution of Bitcoin price versus the Federal Funds rate from January 1, 2015 to February 28, 2021. The two vertical gray lines mark March 3 and March 16, 2020, highlighting the dramatic cuts in the Federal Funds rate of 50 and 100 basis points, respectively. The Federal Funds rate is the interest rate charged to banks on overnight loans of excess reserves they hold at the Federal Reserve.
Why does rising interest rates affect the cryptocurrency market?
Rising interest rates tend to depress cryptocurrency markets, leading to price declines and bankruptcies due to reduced investor risk appetite, increased opportunity costs and higher margin calls.
Investors’ risk appetite declines
As mentioned earlier, rising interest rates make safe haven assets such as bonds more attractive. Investors seeking higher returns may be less willing to take risks on volatile cryptocurrencies when they can get guaranteed returns through low-risk AAA-rated government bonds.
Low-risk AAA government bonds are debt securities issued by governments with the highest credit ratings, providing reliable income with minimal risk of default. This shift in investor sentiment could lead to less demand for cryptocurrencies, driving down prices.
Increased opportunity cost
When interest rates rise, the potential returns from holding cash or other interest-earning assets become more attractive. This increases the opportunity cost of holding riskier assets such as equities, venture capital and cryptocurrencies.
Margin Call and Leverage Pain
The cryptocurrency market thrives on leverage, where investors borrow money to amplify potential gains. However, rising interest rates make these loans more expensive to service. During an economic downturn, investors may face margin calls, forcing them to sell their cryptocurrency holdings to meet their obligations. This forced selling could exacerbate price declines.
The knock-on effects of rising interest rates leading to falling cryptocurrency prices and increased margin calls have led to several bankruptcies throughout 2022, such as Celsius and FTX.
4. Counterarguments surrounding the impact of Federal Reserve interest rates on cryptocurrency holders
Short-term fluctuations in Fed policy may have less of an impact on long-term cryptocurrency investors, as they believe in the long-term potential of cryptocurrencies and are willing to ride out periods of volatility.
Additionally, the Fed’s actions that could destabilize the traditional financial system could fuel distrust in fiat currencies. This could benefit cryptocurrencies in the long run, as some see them as an alternative to government-backed money.
Additionally, if rising interest rates are accompanied by persistently high inflation, specific cryptocurrencies may still be viewed as inflation hedges. This is especially true for cryptocurrencies with limited supply, which could increase their appeal in an inflationary environment. These factors add to the complexity, meaning that while Fed rate hikes could have a negative impact on cryptocurrencies, the long-term relationship is far from clear.
Regardless, the Fed’s interest rate decisions will undoubtedly continue to play a major role in the future of the cryptocurrency market. While the short-term impact appears to be negative, a more stable interest rate environment could foster long-term growth for the industry. Only time will tell how the complex interplay between the Fed and the cryptocurrency market unfolds. However, understanding this relationship is crucial for anyone considering entering the world of cryptocurrency.
