Interest rates and cryptocurrencies
Changes in interest rates affect cryptocurrency prices through changes in investor behavior and market dynamics. The Federal Reserve of the United States of America, known as the Fed, acts as the central bank of the United States. One of the Fed’s key responsibilities is to manage interest rates, which essentially control the cost of borrowing money. Lower interest rates make borrowing cheaper, increase economic liquidity, and encourage consumption and investment. Conversely, raising interest rates discourages borrowing, reduces the flow of money in the economy, and slows down the economy, with the aim of curbing inflation. Asset prices, including stocks, bonds, and even cryptocurrencies, tend to react inversely to interest rates. The interest rate can be visualized as a common factor used to determine the price of an asset. If this factor increases, most of the asset falls in price and vice versa. Therefore, highly volatile assets such as cryptocurrencies also accompany traditional markets (real estate, stocks…). In terms of investor behavior, when rates are low, banks offer lower interest rates on savings. As a result, investors are looking for other types of assets like cryptocurrencies to generate higher returns. This increased demand can drive up cryptocurrency prices. On the other hand, rising interest rates make safe assets like savings accounts and bonds more attractive, thereby detracting from cryptocurrency investments and potentially leading to falling prices. The impact of interest rates is particularly pronounced in risky assets. This is evident from historical price movements within the cryptocurrency market. As cryptocurrency prices fall, liquidity leaves decentralized finance (DeFi) protocols, and blockchain ecosystems begin to look empty, without many users or transactions, and all of this continues while interest rates are high.
Source: cointelegraph
Historical correlation between prices and interest rates
While the link between interest rates and cryptocurrency prices is not always direct, historical trends clearly show the impact of interest rates on Bitcoin price dynamics, which further spills over into the broader market for cryptocurrencies, NFTs, and DeFi protocols. Bitcoin (BTC), the largest cryptocurrency by market capitalization, has a complex relationship with the Federal Reserve’s interest rate decisions. While the correlation is not always perfect, historical trends provide a somewhat visible correlation. If we go back to 2018. year, when the then Fed Chair, Janet Yellen, began a series of interest rate hikes with the aim of curbing inflationary pressures, we will see that this period coincided with a dramatic drop in the price of Bitcoin. From a peak of nearly $20,000 in December 2017. In 2018, Bitcoin had fallen to around $3,200 by December 2018. years, a drop of more than 80 percent. As the price of Bitcoin fell, so did the entire crypto market. While other factors, such as currency exchange hacking and regulatory uncertainty, played a role, rising interest rates were certainly the main reason for this bear market. If we go to 2021. year, when Bitcoin, fueled by the Fed’s low interest rates during the pandemic, reached a record high of over $69,000 in November 2021. years. However, the Fed’s shift in stance on interest rates and broader monetary policy began in late 2021. years. With inflation concerns, the Fed has signaled its intention to raise interest rates and reduce liquidity in the economy. This reversal led to a significant correction in the cryptocurrency market in the coming months. By June 2022. In 2010, Bitcoin lost over 70% of its value, and fell below $20,000 again.
Source: cointelegraph
The chart above shows the price movement of Bitcoin along with the Fed’s interest rate of 1. January 2015. to 28. February 2021. The Federal Interest Rate is the interest rate that banks charge each other for loans of their surplus reserves that they hold with the Federal Reserve.
Why Are Rising Interest Rates Affecting the Crypto Market?
Rising interest rates tend to dampen the crypto market with increased opportunity cost and amplified margin calls, leading to falling prices and very often bankruptcies.
Reduced investor's risk appetite
As mentioned earlier, rising interest rates make safe investments like bonds more attractive. Investors looking for higher returns may be less inclined to invest in volatile cryptocurrencies when they can get a guaranteed return on a low-risk, AAA-rated bond. AAA-rated bonds are securities issued by governments with the highest credit ratings, offering reliable income with minimal risk of default. This change in investor sentiment can lead to a decrease in demand for cryptocurrencies, thereby lowering their prices.
Increased opportunity cost
When interest rates rise, the potential returns from holding cash or other interest-bearing assets become more attractive. This increases the opportunity cost of holding riskier assets like stocks and cryptocurrencies.
Margin calls
The crypto market is flooded with leverage, where investors borrow money to maximize their potential gains. However, rising interest rates make these loans more expensive. In the event of a market downturn, investors may face margin calls, forcing them to sell their crypto assets to meet their obligations. This forced selling can further exacerbate price drops. All this sooner or later caused several bankruptcies, such as Celsius and FTX, during 2022. years.
Source: cointelegraph
Counterarguments about the impact of Fed interest rates on cryptocurrencies
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 prepared to withstand periods of volatility. Additionally, the Fed’s moves 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 money. Furthermore, certain cryptocurrencies could still be considered a hedge against inflation if the increase in interest rates is accompanied by persistently high inflation. This is especially true for cryptocurrencies with limited supply, which can increase their attractiveness in an inflationary environment. These factors add complexity, suggesting that while the Federal Reserve’s interest rate hikes may negatively impact cryptocurrencies, the long-term relationship is not entirely clear. Nonetheless, the Fed’s interest rate decisions will undoubtedly continue to play a significant role in the future of the crypto market. While the short-term impact appears to be negative, a more stable interest rate environment could fuel the industry’s long-term growth. Only time will tell how the complex relationship between the Fed and the crypto market will evolve, but understanding this relationship is crucial for anyone considering entering the world of cryptocurrencies.
Source: cointelegraph
Conclusion
The Fed’s rising interest rates are having a significant impact on the crypto market, reducing investors’ risk appetite, increasing opportunity costs, and amplifying margin calls, leading to falling prices and bankruptcies. Historical trends, such as the events of 2018. and 2021. years, clearly show how interest rate decisions can shape the dynamics of cryptocurrency prices. While short-term changes in interest rates negatively affect cryptocurrencies, long-term investors often believe in their potential and are willing to withstand volatility. Moves by the Fed that undermine confidence in fiat currencies may also benefit cryptocurrencies in the long run. Additionally, some cryptocurrencies may be considered a hedge against inflation, especially in conditions of high inflation and limited supply. Therefore, while the Fed’s interest rates play a key role in the short-term movement of cryptocurrency prices, the long-term effects remain complex and unclear. Understanding this relationship is crucial for anyone considering investing in cryptocurrencies. We hope you enjoyed reading today’s blog, and that you learned something new, if you have any questions or suggestions, you can always contact us on our social networks (Twitter, Instagram).
