Without Precedent: How Will Cryptocurrencies React To Rising U.S. Interest Rates?
2022.05.05 11:58
- Uncharted territory for cryptos
- So far, so good—not
- Creating a forward curve is critical
- A regulatory weapon
- Expect volatility because there are no historical precedents
Throughout most of 2021, the Federal Reserve and the U.S. government blamed rising prices on “transitory” pandemic-inspired supply-chain bottlenecks. The term has become a rallying point for Fed critics, blaming the central bank for the highest inflationary pressures in more than four decades. While the government’s characterization of inflation as “transitory” was politically convenient rhetoric, it was unforgivable for the politically neutral central bank.
In late 2021, when the FOMC members experienced the epiphany that the economic condition was more structural than temporary, the Fed continued to crawl at a snail’s pace in addressing the rising prices with monetary policy. Quantitative easing that pushed interest rates lower further out along the yield curve did not end until early March 2022, and liftoff from a 0% Fed Funds rate did not occur until the March 2022 meeting. Meanwhile, in March 2022, CPI and PPI rose to 8.5% and 11.2%, respectively, the highest level in four decades. Now, the Fed is far behind the inflationary curve. Cryptocurrencies do not have much experience in an inflationary environment, where the Fed pushes rates higher.
Uncharted Territory For Cryptos
Many cryptocurrency market supporters viewed the asset class as a hedge against inflation. The economic condition erodes fiat currency values as governments can issue legal tender to their heart’s content, expanding the money supply. Crypto supplies are limited to mining and other activities, making them an alternative to the fiats, as the conventional money supply grows to stimulate the economy.
Inflation began to rise in the second half of 2020 and exploded higher in 2021. The leading cryptocurrencies reached record peaks on Nov. 10, 2021, as inflation rose and monetary policy fell far behind the inflationary curve.
Bitcoin Daily Chart.
The chart shows Bitcoin peaked at $68,906.48 on Nov. 10, 2021.
Ethereum Daily Chart.
Ethereum reached a record high of $4,865.426 on the same day. The leading cryptos turned lower, reaching the most recent lows on Jan. 24, 2022.
On Wednesday, the Fed hiked interest rates 50 basis points higher and outlined its plans to reduce its swollen balance sheet. As the Fed addresses rising inflation, crypto values remain closer to the Jan. 24 low than the Nov. 10, 2021, high.
So Far, So Good—Not
The tidal wave of central bank liquidity and tsunami of government stimulus that began in 2020 planted inflationary seeds that sprouted during the second half of 2020 and bloomed in 2021 and over the first four months of 2022. The Fed is now addressing inflation, but the war in Ukraine adds another dimension to the economic condition.
Commodity prices recently declined from the multi-year, or in some cases, new all-time highs, but they remain closer to highs than the lows. Bitcoin, Ethereum, and many other cryptos are either telling us that the Fed will have a significant impact on inflation, or they are not inflation hedges and barometers. Ethereum was at the $2,830 level on May 3, with Bitcoin at $38,325.
So far, the cryptos have not been the inflation barometers many had hoped for, but they are responding to a rising interest rate environment as the prices remain depressed compared with the mid-November 2021 highs.
Creating A Forward Curve Is Critical
Cryptocurrencies remain a burgeoning asset class that has made strides toward the mainstream, but they still lack the liquidity of the stock, bond, traditional currency, or commodity markets. Moreover, many voices refuse to acknowledge their value, utility, and role as assets.
Last weekend, at the annual Berkshire Hathaway (NYSE:BRKa) carnival in Omaha, Nebraska, the company’s oracle and famed investor Warren Buffett said:
“”
Buffett does not believe Bitcoin or the other more than 19,200 cryptocurrencies are “productive assetsHis plain-speaking partner, Charlie Munger, went further, saying:
“.”
Munger went on to say Bitcoin “is stupid because it’s still likely to go to zero and is evil because it undermines the Federal Reserve System.”
When it comes to comparisons, he cited “the communist leader in China. He was smart enough to ban Bitcoin in China.”
In response, Elon Musk cynically tweeted:
“.”
The tension between supporters and detractors continues to be a debate over the cryptocurrency asset class’s future. One of the critical goals for cryptocurrency growth is establishing a liquid and transparent forward curve to set future values.
A Regulatory Weapon
U.S. regulators have not supported a borrowing and lending business for cryptocurrencies, which is the crucial factor that creates future values. While the CME introduced mini-Bitcoin and Ethereum futures options, the forward curve remains illiquid, restricting the asset class’s growth.
The regulators claim that allowing cryptocurrency borrowing and lending would increase the illegal uses of the financial instruments. However, buried in Munger’s comments are the underlying reasoning for regulatory resistance. “Undermining the Federal Reserve System” is the most telling comment, as cryptocurrencies take control of the money supply away from governments and return it to individuals as price levels are solely a function of bids and offers for the cryptos.
The bottom line is the regulatory roadblock in front of a forward curve is a front line in the war between traditional financial interests and the evolution of the fintech revolution, and the regulators’ weapon of crypto destruction.
Expect Volatility Because There Are No Historical Precedents
While rising inflation and higher interest rates may impact cryptocurrency values, there is no historical data. The asset class is only a dozen years old and has not experienced economic cycles. Moreover, active trading and investing in cryptos have only occurred over the past five years since the CME introduced Bitcoin futures, increasing the market’s liquidity. A forward curve would go a long way to furthering liquidity, but the war between detractors and supporters is likely to continue to thwart the move towards mainstream assets.
Cryptos remain highly speculative financial products with the potential for the ubiquitous utility that threatens the status quo. Traditional financial institutions and governments will continue to establish roadblocks, while crypto supporters and speculators will find ways around them. Expect lots of price variance in the market that is setting historical precedents each day but has few to use as reasoning for price moves. The jury is still out on the impact of rising U.S. rates on the asset class, and it will take months, if not years, to establish patterns that may create correlations.
