The interest rates set by the Federal Reserve (the US central bank) play a crucial role in guiding US monetary policy and determining borrowing costs. By controlling interest rates, the Fed seeks to achieve economic stability, either by stimulating economic growth or curbing inflation. But how do these changes in interest rates affect the cryptocurrency markets? That’s the question we’ll try to answer in this article.
What are the interest rates at the US Federal Reserve?
The federal funds rate is the rate that banks charge each other on overnight loans. These rates are a key tool the Fed uses to control liquidity in the market. When interest rates are low, borrowing becomes cheaper, which stimulates economic activity and increases liquidity in the market. Conversely, when the Fed raises interest rates, the cost of borrowing rises, which reduces liquidity in the market in order to control inflation.
The relationship between interest rates and cryptocurrencies
The impact of interest rates on cryptocurrencies can be analyzed through two main factors: **change in investor behavior** and **liquidity effect**.
1. Changing investor behavior:
- When interest rates fall, returns on safe financial instruments such as bonds and savings accounts fall, prompting investors to look for higher-yielding assets, even if they are riskier, such as cryptocurrencies. This leads to increased demand for cryptocurrencies and higher prices.
- Conversely, when interest rates rise, safe instruments such as bonds become more attractive, as they offer guaranteed returns compared to cryptocurrencies, which are considered high-risk assets. As a result, investors may resort to selling some of their crypto assets and shifting their investments to more stable instruments.
2. Liquidity effect:
- Raising interest rates reduces liquidity in the market. Liquidity is the factor that allows investors to easily convert their assets into cash, which increases their ability to invest in new assets or enhance their existing investments. When liquidity decreases, the market is directly affected, and this can lead to a decrease in demand for cryptocurrencies, and thus a decrease in their prices.
On the other hand, lower interest rates increase the liquidity available in the market, and give a boost to investments in risky assets such as cryptocurrencies.
Examples from the history of the cryptocurrency market
- Year 2018:
That year, the Fed, led by then-chair Janet Yellen, raised interest rates several times to address inflation concerns. This period saw a significant drop in the price of Bitcoin and other cryptocurrencies. After hitting a record high of nearly $20,000 in December 2017, Bitcoin’s value fell sharply to around $3,200 by December 2018, a drop of more than 80%.
- Year 2021:
2021 saw a huge surge in cryptocurrency prices, driven by the Federal Reserve’s low interest rates during the COVID-19 pandemic to stimulate the economy. Bitcoin hit an all-time high above $68,000 in November 2021. But as the Fed began to adjust its monetary policy and raise interest rates again in late 2021, cryptocurrencies experienced a sharp correction in value in the following months.
Why do interest rate hikes affect cryptocurrencies?
1. Reduce risk appetite:
Rising interest rates make safe financial instruments such as government bonds with high credit ratings more attractive to investors. These bonds offer guaranteed returns with very low risks, reducing investors’ willingness to take on high risks by investing in cryptocurrencies.
2. Increased opportunity cost:
Rising interest rates make holding cash or investing in assets with guaranteed returns more attractive than riskier investments like cryptocurrencies. Therefore, it becomes difficult to justify holding crypto assets when investors can get guaranteed returns through less risky financial instruments.
3. The effect of financial leverage:
The cryptocurrency market relies heavily on leverage, where investors borrow to increase their potential returns. As interest rates rise, borrowing becomes more expensive, which reduces leverage and increases forced selling to meet margin requirements, further depressing prices.
Another view: Long-term impact
Some may argue that the negative impact of higher interest rates on cryptocurrencies is short-term. Investors who believe in the future value of cryptocurrencies may be willing to tolerate short-term volatility and wait for longer periods to realize gains. Additionally, higher interest rates may have a negative impact on confidence in the traditional financial system, making cryptocurrencies more attractive as a long-term alternative.
Conclusion
Ultimately, the impact of the Fed’s interest rate decisions on the cryptocurrency market remains complex and multifaceted. Despite the short-term negative effects that may accompany higher interest rates, the future of cryptocurrencies remains promising for investors who believe in their long-term potential.
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