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Interest rate fluctuations affect the dynamics of the market and investor behavior, which in turn affects the price of cryptocurrencies.
Fed Rates Contrasted With Cryptocurrency
The Federal Reserve, also known as the Fed, serves as the country’s central bank. Controlling the nation’s interest rates, which essentially set the price of borrowing money, is one of its main duties. Reduced interest rates lead to decreased borrowing costs, more economic liquidity, and a rise in investment and consumer expenditure. In contrast, increasing interest rates slows down the economy, discourages borrowing, and decreases the quantity of money flowing through it—all of which work together to control inflation.
The prices of assets, such as bonds, stocks, and even cryptocurrencies, typically have an opposite relationship with interest rates. Generally speaking, an asset’s price can be represented by the interest rate as a common denominator. The price of most assets decreases if the value of this denominator rises, and vice versa. Consequently, this also applies to extremely volatile assets, such as cryptocurrencies and nonfungible tokens (NFTs).
From a behavioral standpoint, banks offer lower savings rates during periods of low interest rates. In an effort to increase their profits, investors are therefore more inclined to go for riskier assets like venture capital and cryptocurrency. The demand for cryptocurrencies may increase. Conversely, if interest rates rise, investors become more drawn to safe-haven investments like bonds and savings accounts, which may result in price declines for riskier initiatives like cryptocurrencies.
Interest rate effects are more noticeable in riskier investments. Due to their inherent volatility and absence of a well-established financial history, cryptocurrencies are particularly vulnerable to shifts in the environment of interest rates. Historical price movements in the bitcoin market provide proof of this. Liquidity departs decentralized finance (DeFi) protocols when cryptocurrency prices plunge, and blockchain ecosystems begin to resemble deserted villages with few users and transactions.
Interest Rate and Bitcoin Price Correlation
Historical trends demonstrate how interest rates affect the dynamics of Bitcoin’s price, even though they are not always direct. These effects also ripple through the NFT and DeFi markets.
The biggest cryptocurrency by market capitalization, Bitcoin (BTC), and the Fed’s interest rate choices have a complicated history together. Even though there are occasionally errors in the correlation, historical trends provide a clear picture. The way that interest rates have affected the price of Bitcoin has had a ripple effect on the cryptocurrency, NFT, and DeFi sectors.
Going back to 2018
The Fed started raising interest rates during the tenure of former Chair Janet Yellen in an effort to allay fears about inflation. The price of Bitcoin fell dramatically during this time. Bitcoin crashed to about $3,200 by December 2018 from a peak of almost $20,000 in December 2017, a startling loss of more than 80%.
The price of all cryptocurrencies fell along with Bitcoin. This crypto winter was definitely influenced by the rising interest rate environment, even though other elements like exchange hacks and regulatory uncertainty also played a part.
Let’s go ahead to 2021.
Thanks in part to the Fed’s exceptionally low interest rates during the pandemic, Bitcoin reached a record high of more than $68,000 in November 2021. Pundits were demanding that the price of Bitcoin reach $100,000, and excitement was at its height.
But in late 2021, the Fed started to change its position on interest rates and more general monetary policy. The Fed made it clear that it intended to hike interest rates and decrease the amount of liquidity in the economy as inflationary fears reappeared. The cryptocurrency market saw a large correction in the months that followed this hawkish turn. By June 2022, Bitcoin had lost more than 70% of its value and had fallen below $20,000.
Fed Fund Rates versus. Bitcoin Price
The Bitcoin price evolution is shown in the above chart from January 1, 2015, to February 28, 2021, along with the Federal funds rate. On March 3, 2020, and March 16, 2020, respectively, two vertical gray lines indicate the major reductions of 50 and 100 basis points in the Fed Funds rate. The interest rate that banks charge one another for overnight loans of their excess reserves that are kept at the Federal Reserve is known as the Federal funds rate.
Why is the Cryptocurrency Market Affected by Rising Interest Rates?
Due to decreased investor risk appetite, higher opportunity costs, and more frequent margin calls, rising interest rates have a tendency to depress the cryptocurrency market, resulting in price declines and bankruptcies.
A Decrease in the Willingness of Investors to Take on Risk
As was previously indicated, safe-haven investments like bonds become more appealing as interest rates rise. If investors can earn a guaranteed return on a low-risk AAA-rated government bond, they might be less inclined to take a chance on volatile cryptocurrencies in search of bigger yields.
Minimal danger The governments that issue AAA government bonds have the best credit ratings and provide dependable income with low default risk. The demand for cryptocurrencies may decline as a result of this change in market opinion, which would drive down prices.
A Higher Opportunity Cost
The potential returns from keeping cash or other interest-bearing assets increase in value as interest rates rise. The opportunity cost of owning riskier assets, such as stocks, venture capital, and cryptocurrency, rises as a result.
Leverage agony and margin calls
The leverage that allows investors to borrow money to increase their potential earnings is what drives the cryptocurrency market. Rising interest rates, however, increase the cost of servicing these loans. Investors may get margin calls during a downturn, which would compel them to sell their cryptocurrency assets in order to pay their debts. Price reductions may be made worse by this forced selling.
Throughout 2022, multiple bankruptcies, including Celsius and FTX, were caused by the cascading effects of rising interest rates, which also caused a decline in cryptocurrency prices and an increase in margin calls.
Arguments Against the Fed’s Interest Rate Policy’s Effect on Cryptocurrency Owners
Long-term cryptocurrency investors may be less affected by short-term changes in Fed policy since they are prepared to endure periods of volatility and believe cryptocurrencies have great long-term potential.
Furthermore, Fed policies that threaten to topple the established financial system could increase skepticism about fiat money. Long-term benefits could result from this, since some people view cryptocurrencies as a substitute for money that is supported by the government.
Furthermore, if rising interest rates are coupled with consistently high inflation, some cryptocurrencies may still be seen as an inflation hedge. This is especially true for limited-edition cryptocurrencies, which could make them more appealing in an environment of inflation. These additional variables create complexity, suggesting that although a rise in Federal Reserve interest rates may have a negative effect on cryptocurrencies, the link over time is far from straightforward.
Nevertheless, the Fed’s decisions on interest rates will surely continue to have a big impact on the direction of the cryptocurrency market. Even while the short-term effects appear to be negative, the industry may see long-term growth in the event of more stable interest rates. The intricate relationship between the Fed and the cryptocurrency market will only become clear with time. However, anyone thinking about getting into the cryptocurrency space needs to grasp this relationship.
