Cryptocurrency has continued to present an alternative route to fiat currency, but the question that has remained on the mind of many speculators is how it will hold up in the coming months as interest rates are set to get hiked.
The Federal Reserve has said it would soon begin raising interest rates; in light of this, what is the fate of cryptocurrency? In light of the continued adoption and the use cases of cryptocurrencies, how will the increased interest rates affect cryptocurrency? Let’s investigate together:
Low-interest rates and the birth of the bitcoin
For Bitcoin, the lead cryptocurrency born in the times of low-interest rates; The world's first decentralized digital currency was first mined and traded in 2009, at a time when central banks were using unprecedented stimulus in an effort to keep borrowing costs minimal. Following the financial crisis, these institutions cut their benchmark rates close to zero and engaged in asset-purchase programs to meet this objective.
Interest rates dropped sharply because of these efforts, and as a response, investors began reassessing available opportunities considering the low-yield environment. What did this mean for bitcoin? For one, investors found the digital currency more compelling since the opportunity cost of foregoing interest-rate payments was lower.
In this low-rate environment, one could argue that investors saw bitcoin as having similar incentives to other safe-haven assets, for example, bonds. As long as the interest payments provided by these safe assets were modest, investors had little reason to seek them out over bitcoin.
As the market stabilized and the need to tackle inflation led to increased interest rates, Bitcoin has risen in value. The general penetration of crypto has become more of a reality, with the price.
More crypto and the Feds
Today, Bitcoin is the leading cryptocurrency in the crypto market, however, due to the penetration level of cryptocurrencies which is on the high side, crypto is gaining increasing acceptance. As adoption goes up, the effects are beginning to show.
In recent times, things are getting cold in crypto-land. Bitcoin is down dramatically from its November peak of close to $69,000, falling to a six-month low below $38,000 at some point in January. At the moment, it has yet to break the $45,000 landmark. Trading volumes have slumped.
It is not just Bitcoin, other cryptocurrencies are also going in the downward direction as well. It is enough that some investors are concerned that the market is going into a "crypto winter" — a period when prices fall sharply and fail to recover for more than a year — as the Federal Reserve abruptly tightens monetary policy.
While other central banks may keep their monetary policy loose, the Fed is expected to tighten the interest rate in order to slow increasing inflation. The U.S. Consumer Price Index (CPI) rose 7% in December from 12 months earlier, the highest annual inflation rate since 1982. President Joe Biden has said it's “appropriate” for the central bank to “recalibrate” its monetary policy.
To combat rising inflation rates, the Fed may raise interest rates sooner than previously planned, according to minutes from a Federal Reserve meeting. The prospect of a rise in borrowing rates impacted most markets, crypto or otherwise.
Why is the interest rate that important?
Generally, higher interest rates increase the value of a country's currency. Higher interest rates tend to attract foreign investment, increasing the demand for and value of the home country's currency.
This is why interest rates are important in the conversation of how the economy of a country is performing. The United States is no different. There is more to it though, one of the primary complicating factors is the relationship that exists between higher interest rates and inflation. If a country can achieve a successful balance of increased interest rates without an accompanying increase in inflation, its currency's value and exchange rate are more likely to rise.
It is not that the interest rate is the golden key that unlocks the worth of a country’s currency. There are still factors including political and economic stability and the demand for a country's goods and services—that are often of greater importance. Factors such as a country's balance of trade between imports and exports can be a crucial factor in determining currency value. That is because greater demand for a country's products means greater demand for the country's currency as well.
Favorable numbers, such as the gross domestic product (GDP) and balance of trade are also key figures that analysts and investors consider in assessing a given currency.
Another important factor is a country's level of debt. High levels of debt, while manageable for shorter periods, eventually lead to higher inflation rates and may ultimately trigger an official devaluation of a country's currency.
How will cryptocurrency fare?
The last time the Fed raised interest rates was in 2018. This gives a little bit of insight into how the leading Crypto, Bitcoin, was able to fare in that period. This does not mean that the same process will occur again, however, it can present a window with which we can view how this will pan out.
The leading cryptocurrencies might see some easing out as the news hit and the regulation goes into play. Already, the market is reacting to the news and the downward movement of cryptocurrencies have disturbed some investors. However, this seems only temporary at best. This is because despite the moves by the Fed, crypto adoption continues to rise, Paypal is exploring the idea of launching a token, several other companies are looking at the prospect too. One thing is clear, the increased interest rate will affect the cryptocurrency ecosystem but adoption will continue to march on and marshal strength.
Stable coin to the rescue
Higher interest rates on dollar-denominated assets will likely increase demand for the dollar and could result in a strengthening greenback in 2022. This could translate this year into higher demand for stablecoins, particularly dollar-pegged stablecoins.
“Stablecoins are a ‘medium’ between fiat currencies like the dollar and cryptocurrencies," said Scott Bauer, a former Goldman Sachs trader who's now CEO of Prosper Trading Academy. "Given that the Fed is likely raising interest rates multiple times this year, which should essentially provide tailwinds for the dollar, stablecoins which are tied to the dollar can also capture this upside.” He is not the only investor who is bullish on stablecoins.
“If global inflationary concerns persist and [stablecoins] become more globally ubiquitous, there's no reason we wouldn't see a continued march upwards for USD stablecoin market cap due to inflows from other nations with struggling currencies,” Sean Farrell, head of digital asset strategy at FundStrat, said. “Ironically, this would result in a more robust crypto ecosystem and increased USD dominance.”
“The USD is still losing value against many other asset classes,” said Farrell. “Thus, while some traders might seek near-term shelter in stables, the cause would be macro uncertainty, not so much a preference for the dollar over bitcoin.”
Since Stablecoins are cryptocurrencies that attempt to peg their market value to some external reference. Stablecoins achieve their price stability via collateralization (backing) or through algorithmic mechanisms of buying and selling the reference asset or its derivatives. They stick to the pegged currency, in this case, the USD.
While it is undeniable that the Fed action will affect the price of cryptocurrencies in the short term, the long term outlook of the market stands secure. The adoption of cryptocurrencies and the propagation of its use cases will continue to gain ground in the short as well as long term.