What is the Federal Interest Rate, Why Do Investors Care About It, and How Does It Impact Cryptocurrencies?
First of all, the federal interest rate is the percentage set by the Federal Reserve, the central bank of the United States, which is imposed on commercial banks to lend to each other. Please note that most global banks follow the Federal Reserve in case of raising or lowering. In other words, this rate is used as a main tool in monetary policy to control (i.e. a control machine) inflation and stimulate or slow down the economy.
Imagine the economy is a car, and the federal funds rate is the gas pedal or brake. When the Fed (like the driver of a car) wants to speed up the economy, it lowers the interest rate, like pressing the gas pedal. When it wants to slow the economy down, it raises the interest rate, like pressing the brake.
How does interest rate affect investor sentiment? And why do all investors care about interest rates?
To put it more simply, imagine that you are an investor and you have a sum of money that you want to invest to achieve good returns. You have two options:
The first is a safe option: you can put your money in a bank or buy government bonds. These investments are considered safe and provide a fixed return, but they are not high-yielding.
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The second is a riskier option: You can invest your money in something that is considered riskier (like cryptocurrencies) but offers greater potential for returns.
How does the interest rate decision affect your decision in both cases (i.e. raising or lowering the interest rate)?
When the interest rate is low:
The return from the safe option (bank or bonds) will not be attractive, because the interest offered by the bank is low. In this case, you may feel that it is better to take the risk and put your money in high-risk investments such as cryptocurrencies because they may give you much higher returns.
When interest rates are high:
Suddenly, the safe option becomes more attractive. The interest rates offered by the bank or bonds become high enough to provide you with a good return without having to take any risk. So, you may decide to withdraw your money from high-risk investments (such as cryptocurrencies) and put it in something safe and stable.
A practical example of this to bring the picture closer and closer
Imagine you have two friends; the first (Ahmed) invites you to invest your money with him in a new project to sell coffee online. This project is new and full of risks, but it could bring you great returns if it succeeds.
While your other friend (Mohamed) offers to deposit your money in a fixed-interest savings account. If the interest offered by Mohamed is low, you might choose to invest with Ahmed, because the risk may be worth the potentially high return.
But if Muhammad increases the interest, you will think twice, and you may prefer to invest with Muhammad because he provides you with a guaranteed return without risking your money.
Now let's talk about the impact of federal interest rates on cryptocurrency prices.
Federal interest rates affect cryptocurrencies in several ways:
First: Impact on investor morale:
By increasing interest rates: When the Fed raises interest rates, the cost of borrowing becomes higher, which typically leads to less investment in riskier assets like cryptocurrencies. This leads to a decrease in demand for cryptocurrencies, causing their prices to fall.
When the Fed lowers interest rates, the cost of borrowing decreases, which increases the appetite for riskier assets and thus, the demand for cryptocurrencies may increase, leading to an increase in their prices.
Secondly, the impact on liquidity:
When interest rates increase, the liquidity available in the markets, including the cryptocurrency markets, decreases. It becomes difficult to buy or sell cryptocurrencies in large quantities without affecting the price, which leads to increased price volatility and possibly lower prices.
Lowering interest rates also increases liquidity in the markets, which enhances the ability of investors to invest in crypto assets. This additional liquidity could lead to higher cryptocurrency prices.
Letâs say youâre thinking about investing in something like cryptocurrencies. If the interest rate is low, you might be more willing to risk your money on such an investment. But if itâs high, you might decide to keep your money in safer investments like a savings account or government bonds.
The bottom line: Fed rate hikes reduce risk appetite among investors and reduce liquidity in the markets, which can cause cryptocurrency prices to fall. Conversely, interest rate cuts can encourage investment in riskier assets like cryptocurrencies, which can lead to higher prices.
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