Ever since I jumped into the crazy world of crypto I have heard about the dream of crypto depegging from TradFi stocks. Not only has that not happened but people are wising up to the factors that influence the market, with one of the key ones being the interest rate decisions made by the United States Federal Reserve (the Fed). As the central bank of the U.S., the Fed has a powerful influence on the economy.
What Are Fed Interest Rates?
The Federal Reserve manages America's interest rates to control the cost of borrowing money. Essentially, influencing how much it costs banks to borrow from each other overnight, known as the Federal funds rate. This impacts the interest rates for loans, mortgages, and savings accounts that banks offer.
When the Fed lowers interest rates, it makes borrowing cheaper, increasing liquidity and encouraging consumer spending and investment. On the other hand, when the Fed raises interest rates, borrowing becomes more expensive, liquidity decreases, and the economy tends to slow down.
Lets look at the effect on crypto when Rates are hiked:
Reduced Risk Appetite
Investors often become more risk-averse. Higher interest rates make safer, more traditional assets like bonds and savings accounts more attractive, as they offer guaranteed returns with lower risk. As a result, riskier assets, including cryptocurrencies, may see decreased demand.
We saw this in 2018 when the Fed raised rates multiple times, leading to a significant drop in Bitcoin’s price from around $20,000 in Dec 2017 to about $3,200 by Dec 2018.
Increased Opportunity Cost
When rates increase, the returns from bonds and savings accounts become more appealing, raising the opportunity cost of holding volatile assets like crypto. For example, when interest rates are low, investors dont care about the risks of Bitcoin and other crypto because they offer the chance for much higher returns. But when the Fed raises rates, the guaranteed returns on low-risk asset outshine the potential (and uncertain) gains from crypto, causing a shift in capital flows away from crypto.
Now lets look at the effect on crypto when Rates are Lowered:
When the Fed lowers interest rates, it can have the opposite effect on crypto. Lower rates reduce the returns on traditional safe-haven assets like bonds, which drives investors to seek higher returns in riskier assets such as Crypto. Remember the ones seen after the onset of the COVID-19 pandemic in 2020, crypto surged in popularity. Bitcoin reached an all-time high of over $68,000 in 2021. With borrowing costs low and liquidity plentiful, investors had the confidence to pour money into riskier investments, including crypto.
