Can Interest Rates Drop Crypto Lower?

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Contributor, Benzinga
September 16, 2022

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The cryptocurrency market has left the bull run of 2019-2021 and plunged straight into another crypto winter. Year-to-date, the price of Bitcoin, Ethereum, DeFi tokens and other altcoins have drawn down significantly from all-time highs. The culprit? A rare combination of soaring inflation plus aggressive Federal Reserve interest rate hikes.

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TLDR: Can Interest Rates Drop Crypto Lower?

Possibly. All things being equal, a higher interest rate increases the cost of borrowing for investors and consumers. Doing so disincentivizes spending in an attempt to bring down inflation and leads to an unwillingness to purchase risky assets such as stocks, real estate and crypto. This attitude is referred to as risk-off, with investors preferring safer assets like short-term bonds and money-market instruments. 

Conversely, cryptocurrencies, and in particular more speculative altcoins, can take off when interest rates drop and trend low. This is exactly what happened in March 2022 during the trough of the COVID-19 crash. The Federal Reserve dropped interest rates and sent the prices of risky assets like stocks and cryptocurrencies soaring in a V-shaped recovery. Either way, cryptocurrency investors should watch interest rates keenly. 

What Are Federal Interest Rates?

Interest rates are formally known as the Fed Funds Rate (FFR). As the central bank and lender of last resort for the financial system, the Federal Reserve (Fed) uses the FFR as a monetary policy tool to influence the economy. 

Primarily, the FFR is used to satisfy one of the Fed's dual mandates — ensuring that inflation, as measured by annual changes in the Personal Consumption Expenditures (PCE) index or PCE and the Consumer Price Index (CPI), remains low and stable. The goal is usually expressed as a 2% long-term target. 

By raising the FFR, the Fed tightens the economy by making capital more difficult to borrow. A higher FFR means a higher cost of lending for businesses, consumers and investors. An increase makes spending and investing in speculative assets less attractive, which in theory should stabilize prices and quell inflation. 

How Changing Interest Rates Affect Cryptocurrencies

Cryptocurrencies are a risk asset. Their high volatility and speculative nature mean that they often hold a high correlation to stocks, especially small-caps, growth stocks or tech-sector companies. Since the start of 2022, BTC has held a 0.77 monthly correlation with the S&P 500 index, which is tech-heavy at 25%, and a 0.82 monthly correlation with the Russell 2000 index, which is entirely composed of small-cap stocks.

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These types of stocks are the ones that tend to be affected most by rising interest rates. Many of these stocks rely on financing to keep growing. Rising interest rates increase the cost of capital for these growth stocks. This factor discounts their future profits further, which further disincentivizes spending and borrowing by these companies. The result can be a fall in their valuation and share price.

The crypto market is no different. During low-interest rate bull markets, many traders and investors use leverage to juice their gains. When interest rates rise, borrowing costs for margin increase. The increase can cause investors to liquidate their positions as they cannot afford the higher payments. Prices drop further, which spurs additional liquidations in a vicious cycle. A broad sell-off may occur in the crypto markets. 

History of Interest Rates Hikes Causing Market Crashes

Investors need to understand that market reactions to interest rate hikes are anticipatory in nature. Often, markets move far in advance of when the actual rate hike is taking place. For example, the cryptocurrency market experienced a correction on September 13, 2022 after CPI readings for August came in above expectation. 

The CPI report showed inflation decreasing to 8.3% instead of the predicted 8.1%, with core inflation trending higher. Accordingly, risk assets sold off, with the tech-heavy Nasdaq exchange losing 4% and Bitcoin losing over 10%. In this case, investors reacted based on their predictions that the Fed will not relent on upcoming rate hikes given that inflation has not abated. 

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Once the rate hike is actually announced, investors can react in unpredictable ways. For example, if the market is expecting a 75-basis point hike, but the Fed only delivers a 50-basis point hike or confirms it with a 75-basis point hike, a rally can occur. In this case, the uncertainty is dispelled, which causes investors to become more risk-on. 

How to Buy Cryptocurrency

Investors interested in buying cryptocurrency can do so via trading platforms like eToro, Public.com, Webull, Crypto.com and Binance. Signing up initially involves a know-your-client (KYC) process where you will have to provide identification to prevent money laundering. Then you can fund an account and purchase cryptocurrencies. 

Choosing the right platform involves assessing the features and incentives each one offers. Some platforms offer staking rewards where you can earn interest by holding crypto with them. Others offer low bid-ask spreads and trading fees. Some provide margin loans for leveraged trading. Depending on your objectives, some of these features might be more useful than others, so it's important to shop around. 

With exchanges, your coins are held in an online hot wallet. This practice can sometimes pose a security risk from hacking or scams. For ultimate protection, crypto investors can transfer their coins to an offline cold wallet for secure self-storage. This process requires high responsibility and technical knowledge, so ensure you're familiar with the process before attempting it. 

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So, Will Interest Rates Drop Crypto Lower?

The latest CPI report has the market speculating about future interest rate hikes. The next one is expected to occur during the subsequent Federal Open Markets Committee (FOMC) meeting on September 20-21. Right now, Fed Fund futures contracts are pricing in a roughly 30% chance of a 100 bps (1%) rate hike. 

Whether interest rates drop crypto lower in the coming weeks depends on how the Fed delivers. If it is aggressive with a 100 basis-point hike, another sell-off is possible. However, if it remains moderate with a 75 basis-point hike as they've done before, prices might remain more stable. A 50 basis-point hike will likely be a surprise and result in a rally. 

The price of crypto is affected by more than just interest rates. Regardless of what the Fed actually delivers, crypto investors should be aware of higher-than-average volatility in the ensuing weeks. Trading activity leading up to a Fed decision can be rather frenetic, so be prepared for fluctuations. 

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