Higher interest rates generally mean a lower appetite for high-risk/high-return assets such as cryptocurrencies, hence we’ve seen the crypto market decline in recent months. With the stock market also reacting badly to recent rate hike and the crypto market becoming increasingly correlated to stocks, crypto could be in for a continued bearish year because of the bearish macroeconomic outlook.
Overview of the Crypto Market’s Dynamics
Since the beginning of the year, the price of Bitcoin has seen a steep decline, which has shaken the investors’ trust and caused them to be concerned about future returns on their investments. However, it is essential to remember that such high volatility is not unprecedented for this asset class; throughout history, comparable cycles of bull and bear markets have been seen in the market. This fact should be taken into consideration. If past performance is any indication, the current bear market seems to be no different and instead presents a chance to get a deeper understanding of this industry.
It is not only the cryptocurrency market that is falling, though. As a result of investors’ concerns that global central banks may be prepared to accept recession to help bring inflation under control, equity markets have also fallen. Since the beginning of 2022, equities, cryptocurrencies, and commodities have seen significant volatility as investors have anticipated increasing interest rates and greater energy costs. But what is in store for the remainder of the year, given that central banks across all developed nations have been raising rates at unprecedented speed and more hikes are likely?
How Higher Interest Rates Affects the Crypto Market?
When short-term interest rates are increased, it becomes more difficult and expensive for both individuals and companies to borrow money, which in turn reduces the amount of money available to circulate throughout the economy. Overall, the correlation between Bitcoin and the stock market is at an all-time high. This indicates that the digital asset is almost in lockstep with the S&P 500… descending together and ascending in tandem.
According to Paddy Osborn, Managing Director/Academic Dean, at the London Academy of Trading, “Although Crypto prices have become more aligned with stock market fluctuations, crypto markets remain ultimately speculative, with many retail traders looking for the next big bubble. Higher interest rates tend to hold back crypto prices since much of this retail speculation is traded on margin and more expensive borrowing rates tend to disincentivise this speculation.”
Ultimately, higher interest rates have two detrimental effects on crypto markets:
- Investing flows into the market decline: The returns on cash (kept in savings accounts) increase when interest rates rise. In response, investors hold more cash (a liquid and low-risk asset) and fewer cryptocurrencies and other higher risk assets. This decreases investment flows into crypto markets and boosts withdrawals, exerting downward price pressure.
- The implied valuations of cryptocurrency projects are reduced: Higher interest rates raise the discount rate applied to a cryptocurrency project’s cash flows, which decreases the project’s worth and the market’s willingness to pay.
Is Bitcoin Still an Inflation Hedge?
Some of BTC’s most fervent proponents have long contended that the world’s largest cryptocurrency was a hedge against inflation due to its restricted supply of 21 million coins – a safe refuge for investors seeking to retain money while major currencies, such as the U.S. dollar, degrade. Nevertheless, despite yearly inflation rates reaching their highest levels in forty years, Bitcoin’s worth has collapsed below $20,000. Does this imply that the adage that Bitcoin is digital gold no longer applies?
Bitcoin’s correlation with traditional assets such as stocks and bonds has historically been relatively low. This may be merely the result of crypto’s speculative appeal as it became a multi-trillion-dollar asset class. It should not come as a surprise that the same macroeconomic factors that influence other major asset classes are starting to adversely affect cryptocurrency markets, since cryptocurrencies are now handled by millions of individuals as well as a significant number of the largest institutions on Wall Street and elsewhere.
Nowadays, the cryptocurrency market is developing into a more mature and efficient ecosystem, and one of the results of these developments is that the market has grown more sensitive to shifts in the macroeconomic environment. This only indicates that it is no longer a game played by a select few crypto-natives in a restricted group.
Risks Perceptions – the Core Drivers of Crypto Investments
Increasing interest rates alters investors’ risk-reward calculations, especially those of bigger investors such as hedge funds. A “safe” investment, such as a bond, may readily attract capital that would otherwise be invested in high risk, high return assets. These riskier investments include all cryptocurrencies and other token assets.
When investors are willing to put their money into riskier investments like Bitcoin and other high-yielding assets, we say that the investing climate is “risk-on”. Investors’ attention has been drawn to Bitcoin during the 2020-21 bull run since it represents a new and developing asset class. As a direct consequence, we saw significant growth in Bitcoin in during this time.
On the other hand, when circumstances are risk averse, or “risk off”, investors try to minimise risk by putting their money into assets that provide safer, more predictable returns. Risk-averse attitudes may be triggered by a variety of circumstances, including earnings downgrades from corporations, a slowdown in economic growth, and many more.
A massive de-risking event has been taking place since late 2021/early 2022, so risk-off assets such as currencies and bonds have been gaining favour as of late. Recently, rates on US government bonds have been climbing steadily despite the volatile market environment. In times like this, investors go for assets that are considered safe havens because they want to avoid risk since they are uncomfortable with it.
Even while the recent stock market and crypto market declines have been challenging for some investors, it has presented a potential opportunity for new investors to enter the market at a level where they have a chance of seeing significant returns – if and when Bitcoin and other crypto markets burst back into life.
Understanding the risks of cryptocurrency markets and the importance of building a robust trading strategy before entering the markets is key to maximising your success. The London Academy of Trading’s cryptocurrency course can help you build a strategy through a combination of practical and theoretical sessions with 10h/day support from their expert team of tutors.