Rate Hikes vs Crypto Hype
A Financial World in Transformation.
The financial markets are undergoing a transformation. Traditionally, interest rates shape investment prospects in assets like bonds and stocks. How do cryptocurrencies, these new players on the financial landscape, react to these same influences? Do the same dynamics apply?
Interest Rates and Financial Markets
Historically, movements in the federal funds rate have had major impacts on financial markets. Lower interest rates tend to encourage borrowing and investing due to the cheaper cost of capital, generally lifting asset prices, while higher rates can cool off overheated markets. In the realm of cryptocurrencies, however, the response is more nuanced.
For example, since 2013, if we observe the relationship between the evolution of Bitcoin prices and the Federal Reserve's key interest rates, the correlation appears positive (0.32) and somewhat weaker at 0.12 between Bitcoin and 10-year Treasury yields.
However, this quick initial analysis offers only a limited view of the dynamics of these correlations over time. Has the correlation remained stable, or has it varied in response to changes in monetary policy? For a better understanding, it is essential to look at how the correlations have evolved over the past decade by evaluating their reactivity to different economic conditions and changes in monetary policy. This article aims to provide a more balanced view of the relationship between macroeconomic policy instruments and the valuation of digital assets over time.
Graph 1: Bitcoin & Federal Reserve Interest Rates
Graph 1 illustrates the evolution of federal funds rates (purple line) and Bitcoin prices (black line). We can observe that a notable rise in key interest rates in 2022 coincides with a significant drop in Bitcoin prices, highlighting the impact of monetary tightening on more volatile investments. The green line at the bottom of this chart, which illustrates a 48-month rolling correlation, shows variations in the relationship between these two measures over time. Notably, it indicates a shift to negative values just before 2021. The gray areas represent periods of rising interest rates.
Before 2020, Bitcoin showed a positive correlation with the federal funds rate. However, starting in January of that year, this correlation began to weaken, turning negative—a trend accelerated by the onset of the COVID-19 pandemic. This inverse correlation aligns with the observation that rising short-term rates are detrimental to more risk-sensitive assets like Bitcoin. As rates were raised in response to inflationary pressures, Bitcoin prices were consequently impacted.
Graph 2: Bitcoin & US 10-Year Treasury Rates
Is the situation different when conducting the same analysis but with 10-year Treasury yields (Graph 2)? Initially, the correlation between Bitcoin prices and long-term interest rates is positive but also quickly turns negative in mid-2020. This suggests an inverse relationship where higher long-term rates could lead to a decline in Bitcoin prices. However, in 2023, the correlation begins to recover, potentially indicating a change in market dynamics or in investor responses to macroeconomic factors influencing both Bitcoin and long-term interest rates.
Understanding the reasons behind these rate hikes is crucial for understanding their impact. Between 2016 and 2019, the Federal Reserve raised its key interest rates to normalize its monetary policy after a period of low rates, which had been maintained to stimulate the economy during and after the 2008-2009 financial crisis. Then, in 2022, rates were adjusted again, this time in response to inflation concerns. Thus, when economic improvement is anticipated, long-term rates and risky assets like Bitcoin can rise together, driven by positive investor sentiment and inflationary expectations. However, when rates rise mainly due to monetary tightening aimed at combating inflation, the cost of capital increases. Consequently, non-income-generating assets such as Bitcoin lose their appeal, resulting in a drop in their value as rates continue to rise.
S&P Global's research report supports this thesis by highlighting a marked correlation between Bitcoin price fluctuations and monetary policy adjustments. Indeed, periods of low interest rates are associated with price appreciation, while rapid rate hikes lead to declines, reflecting broader market trends.
Unique Dynamics
Cryptocurrencies operate according to different dynamics compared to traditional assets. They are largely decentralized, free from government control, and influenced by factors such as technological advances, market adoption, and regulatory changes. S&P Global's analysis highlights that while macroeconomic factors like interest rates influence cryptocurrencies, they are only one of many drivers. Market confidence, technological developments, and liquidity conditions play equally essential roles.
Does the Fed Have a Direct Influence on the Cryptocurrency Market Evolution?
The relationship between federal funds rates and cryptocurrencies, particularly Bitcoin, is evident but complex. While Bitcoin responds to changes in the federal funds rate, it does not do so in isolation. The impact of interest rates must be considered through the lens of broader market conditions, technological advances, and regulatory changes.
In conclusion, while key interest rates are a significant macroeconomic factor, their influence on Bitcoin prices is moderated by several other factors. As the cryptocurrency market matures and institutional involvement increases, the interaction between traditional monetary policy and digital assets could become more pronounced, potentially aligning them more closely with traditional financial market behavior. However, the unique aspects of cryptocurrencies will likely continue to give them a distinct place in the financial landscape.
