Impact of Fed interest rates on crypto holders

Fed interest rates vs. cryptocurrencies

Changes in interest rates impact cryptocurrency prices through shifts in investor behavior and market dynamics.

The United States Federal Reserve, or the Fed, acts as the central bank of the United States. One of its key responsibilities is to manage the country’s interest rates, which essentially control the cost of borrowing money. A lower interest rate makes borrowing cheaper, increases economic liquidity and stimulates consumer spending and investment. Conversely, raising interest rates discourages borrowing, reduces the amount of money flow within the economy and slows the economy down, which aims to curb inflation.

Asset prices, including stocks, bonds and even cryptocurrencies, tend to react inversely to interest rates. As a rule of thumb, the interest rate can be visualized as a common denominator used to price assets. If this denominator increases in value, most assets fall in price and vice versa. Therefore, highly volatile assets like cryptocurrencies and nonfungible tokens (NFTs) are no exceptions to this.

From a behavioral perspective, when rates are low, banks offer lower savings rates. As a result, investors are more likely to seek out riskier assets like venture capital and crypto to pursue higher returns. This increased demand can drive up crypto prices. 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 leading to price drops.

The impact of interest rates is particularly pronounced in riskier assets. Cryptocurrencies, with their inherent volatility and lack of established financial history, are especially sensitive to changes in the interest rate environment. This is evidenced by historical price action within the cryptocurrency market. As the price of cryptocurrencies plummets, liquidity leaves decentralized finance (DeFi) protocols, and blockchain ecosystems start looking like ghost towns without many users or transactions.

Relationship between interest rates and cryptocurrency prices

While not always direct, historical trends underscore the impact of interest rates on Bitcoin’s price dynamics, cascading across the broader cryptocurrency, NFT and DeFi markets.

Bitcoin (BTC), the largest cryptocurrency by market cap, has had a complex relationship with the Fed’s interest rate decisions. While the correlation isn’t always perfect, historical trends paint a clear picture. The effect of the interest rates on Bitcoin prices has had a cascading impact across the crypto, NFTs and DeFi markets.

Rewinding to 2018

Under then-Chair Janet Yellen, the Fed embarked on a series of interest rate hikes aimed at taming inflation concerns. This period coincided with a dramatic decline in Bitcoin’s price. From a peak of nearly $20,000 in December 2017, Bitcoin plummeted to around $3,200 by December 2018, a staggering loss of over 80%. 

As Bitcoin’s price declined, so did the entire cryptocurrency asset class. While other factors like exchange hacks and regulatory uncertainty played a role, the rising interest rate environment was undoubtedly a major contributor to this crypto winter.

Fast forward to 2021

Buoyed by the Fed’s ultra-low interest rates implemented during the pandemic, Bitcoin soared to a record high of over $68,000 in November 2021. Several pundits called for a $100,000 Bitcoin price, and euphoria was at its peak. 

However, a shift in the Fed’s stance around interest rates and broader monetary policy began in late 2021. With inflation concerns resurfacing, the Fed signaled its intention to raise interest rates and reduce the liquidity within the economy. This hawkish turn triggered a significant correction in the crypto market in the following months. By June 2022, Bitcoin had shed over 70% of its value, dipping below $20,000 once again.

The above chart displays the evolution of Bitcoin prices alongside the Federal funds rate from Jan. 1, 2015, to Feb. 28, 2021. Two vertical gray lines mark March 3 and March 16, 2020, highlighting the dates when the Fed Funds rate was significantly cut by 50 and 100 basis points, respectively. The Federal funds rate is the interest rate banks charge each other for overnight loans of their excess reserves held at the Federal Reserve.

Why does rising interest rates impact the crypto market?

Rising interest rates tend to dampen the crypto market due to reduced investor risk appetite, increased opportunity cost and heightened margin calls, leading to price drops and bankruptcies.

Reduced investor appetite for risk

As mentioned earlier, rising interest rates make safe-haven assets like bonds more attractive. Investors seeking higher returns may be less willing to take a chance on volatile cryptocurrencies when they can earn a guaranteed return on a low-risk AAA-rated government bond. 

Low-risk AAA government bonds are debt securities issued by governments with the highest credit ratings, offering reliable income with minimal default risk. This shift in investor sentiment can lead to decreased demand for cryptocurrencies, pushing prices down.

Increased opportunity cost

When interest rates increase, the potential returns from holding cash or other interest-bearing assets become more appealing. This increases the opportunity cost of holding riskier assets like equity, venture capital and crypto.

Margin calls and leverage pain

The cryptocurrency market thrives on leverage, where investors borrow money to magnify their potential gains. However, rising interest rates make these loans more expensive to service. In a downturn, investors may face margin calls, forcing them to sell their crypto holdings to meet their obligations. This forced selling can exacerbate price drops. 

The cascading effects from increasing interest rates resulting in falling crypto prices and increased margin calls led to several bankruptcies like Celsius and FTX throughout 2022.

Counterarguments surrounding the impact of Fed interest rates on crypto holders

Short-term fluctuations in Fed policy may have less influence on long-term crypto investors, as they believe in the long-term potential of cryptocurrencies and are willing to ride out periods of volatility. 

Additionally, Fed actions that could destabilize the traditional financial system could fuel distrust in fiat currencies. This might benefit cryptocurrencies in the long term, as some see them as an alternative to government-backed money.

Furthermore, specific cryptocurrencies might still be viewed as an inflation hedge if rising interest rates are accompanied by persistently high inflation. This is particularly true for cryptocurrencies with a limited supply, which may increase their appeal in an inflationary setting. These factors add complexity, implying that while an increase in the Federal Reserve’s interest rates may negatively impact cryptocurrency, the long-term relationship is far from clear-cut.

Regardless, the Fed’s interest rate decisions will undoubtedly continue to play a significant role in the crypto market’s future. While the short-term impact seems negative, a more stable interest rate environment might foster long-term growth for the industry. Only time will tell how the complex interplay between the Fed and the crypto market unfolds. However, understanding this relationship is crucial for anyone considering venturing into the world of cryptocurrencies.