When interest rates fall, where does the money go?

The US announced a 2 basis point interest rate cut, lowering the original benchmark interest rate from 5.25% to 5.5% to 4.75% to 5%. This move greatly boosted market confidence. In addition to the US S&P 500 index hitting a new high, BTC also broke through integer levels such as 63,000 and 66,000, and the market was filled with joy.

Apart from FOMO, whether there is really a continuous inflow of funds into the market is the key to the long-term appreciation of assets. In the final analysis, where did the funds go after the interest rate cut?

What is market liquidity?

Simply put, good liquidity means that when you buy or sell this product, someone will immediately trade with you, and the price fluctuations are small, and the trading experience is good. On the contrary, poor liquidity means that the transaction is more difficult, it is not easy to find buyers/sellers, and it may lead to larger price fluctuations. In the currency circle, good liquidity includes cryptocurrencies such as BTC and ETH, and lack of liquidity includes commodities such as NFT.

For traders, liquidity is very important because poor liquidity will lead to changes in transaction prices, which may cause traders to suffer losses or even be unable to trade. Therefore, market liquidity is a factor that every trader must consider.

Interest rates and liquidity

First of all, we need to know the impact of interest rates on the entire banking system. The so-called interest rate increase/decrease changes the "benchmark interest rate for overnight lending."

Direct impact of rate cuts: Reduce interbank lending costs / Reduce the cost of banks borrowing money from the central bank

Direct impact of rate hikes: Increases interbank lending costs / Increases the cost of banks borrowing money from the central bank

Here we discuss the interest rate cut part. The interest rate cut will lead to lower borrowing costs for banks, and lower borrowing costs will prompt the following behaviors.

Banks are more willing to increase lending because they can get higher interest margins

Lending standards may be relaxed, allowing more borrowers to get loans

Banks may increase their holdings of long-term assets (such as long-term loans and bonds) (long-term interest rates are less affected by interest rate cuts and can guarantee higher returns)

Bank interest income may be cut in the short term

At this time, banks may face the risk of reduced income, and the original low-risk asset returns can no longer meet the bank's principle of using high returns to attract customers, so they need to seek assets with higher returns, which may lead to rising asset prices and potential bubble formation.

Observation on Liquidity in Cryptocurrency Market

Since the crypto market only developed after the advent of Bitcoin in 2009, historically, the only event in the crypto market that was caused by interest rate cuts due to the epidemic in 2020 can be used as a reference. We can directly look at the chart for comprehensive reference.

Key Indicator 1: Total Crypto Market Value

The total market value is one of the factors that help us understand market liquidity. We can see that after the interest rate cut in 2020, the market value of the crypto market began to rise, reaching a peak of 3 trillion in 2021. However, the total market value will deviate due to currency price fluctuations.

Key Indicator 2: Crypto Market Trading Volume Still Lower Than Past Bull Markets

Trading volume can also be used as one of the market liquidity indicators, because sufficient market liquidity can support high daily trading volumes. According to the current market, a daily trading volume of US$100 billion represents good market liquidity. After the interest rate cut, the daily trading volume also increased due to the market recovery, approaching US$100 billion, and has now fallen back to around US$60 billion.

Key indicator 3: Stablecoin (USDT, USDC, etc.) issuance is close to the peak

The issuance of stablecoins is a more accurate indicator. From the issuance of stablecoins, we can clearly know how much legal currency is needed to enter the current crypto market, and it will not change with the fluctuations in currency prices. The current market value of stablecoins has exceeded the 170 billion US dollar mark, which is at a historical high, indicating that the market liquidity is sufficient.

Although the above three indicators can help us understand the liquidity status of the cryptocurrency circle, the cryptocurrency circle has a unique feature, that is, there are too many investable assets, which may lead to the dispersion and fragmentation of liquidity, and evolve into a situation where everyone has food to eat but no one is full. Investors still need to deal with this part carefully.

The impact and risks of excess liquidity

After saying so much above, it seems that interest rate cuts are all good news, and it would be even better if quantitative easing (QE) was added. In addition to rapid economic development and smooth corporate financing, the financial market would also usher in a carnival. However, everything has two sides. When there is excess liquidity in the market, the following situations may occur.

Asset bubble risk:

The value of this world as a whole continues to grow, but if the growth rate of currency exceeds the growth of value, it is a bubble. Warren Buffett, the stock god, once said: "Prices will eventually reflect value." That means the asset bubble will eventually burst, and by then the assets of most people will shrink significantly, or even lose all their money.

Inflation Risk:

Excess liquidity will further push up commodity prices, leading to excessive inflation, a rapid decline in purchasing power and the collapse of the monetary system. For example, Zimbabwe in 2000 and Venezuela in 2010 both had to abandon their original monetary systems and seek other solutions because of incorrect economic policies that led to excess market liquidity.

Excessive leverage and financial system risk:

When banks have a lot of excess funds, it may lead to lower lending conditions, which may lead to a large number of companies and individuals engaging in leveraged behavior. However, when the policy changes, problems such as broken capital chains and trust crises may easily occur, leading to an imbalance in the overall financial system.

Therefore, market liquidity should be just right. Too much liquidity may lead to economic and market turmoil. We investors must always pay attention to the risks in this regard.

Lowering interest rates is undoubtedly a powerful measure to supplement market liquidity. However, in recent years, due to shock events such as the 2008 financial tsunami and the 2020 epidemic, interest rate cuts and quantitative easing policies seem to have thrown too much money into the market, and the entire market has become a sea of ​​​​money. As an investor, you need to pay more attention to the risks in the market during this period. Making risk-averse decisions at the right time is a necessary measure for us to continue sailing. Only at the poker table will we have the opportunity to continue.