The Fed’s interest rate hikes, in combination with other macroeconomic factors, have sent shockwaves through both the stock and crypto markets. But why is the Fed raising interest rates, and why do they have this effect on markets?
What are interest rates?
If you’ve ever taken out a loan of any kind, you’re familiar with the concept of interest rates. Interest is the cost you pay for borrowing money or some other asset, while an interest rate is the amount of interest that is due to a lender over a certain period of time. An interest rate is usually seen as a percentage of the original amount that was borrowed, which is referred to as the ‘principal.’
What does raising interest rates do?
When we talk about the Federal Reserve and interest rates, we’re referring specifically to what’s called the federal funds rate or the federal funds target rate. The federal funds rate affects the interest that big commercial banks charge each other for overnight loans to ensure they meet liquidity requirements set by regulators. As the big banks raise interest rates for each other, those increased numbers find their way into the loans and products offered to other businesses and individual customers around the world. Loans and interest payments become more expensive. It becomes harder to borrow money, leading to less of it circulating in the economy and less economic activity. If you’ve ever heard the phrase ‘cooling off’ the economy, that’s what this means. Think of every service that requires borrowing money: mortgages, credit cards, student loans, car loans. All are impacted as the Fed tries to combat inflation by raising interest rates, but the effects don’t stop there. The stock, bond, and, most importantly to us, crypto markets are all affected as well.
How does this affect the crypto market?
To answer this question, we first have to understand two types of assets: risk-on and risk-off. Risk-on assets are assets that are considered riskier investments, like stocks, crypto, and currencies from emerging markets. Risk-off assets are assets that are considered safer during times of economic uncertainty, like gold, currencies that are considered more stable like the U.S. dollar and the Swiss franc, and long-term U.S. government bonds. When there’s less money to go around in the economy, that naturally means less money will find its way into risk-on assets like cryptocurrencies and NFTs. We’ve already seen the crypto market take a beating this year, with Bitcoin and Ethereum both down over 70% from their all-time highs set back in November 2021. While this can partly be attributed to institutional investors moving into ‘safer’ assets like gold, U.S. Treasury bonds, and even cash, retail investors are also spooked and trying to salvage their portfolios. This also means that there’s less money for cryptocurrency-related businesses and teams to grow. Where in most of 2020 and 2021 we saw new crypto or NFT projects pop up seemingly every day, the money faucet is being squeezed to a trickle by the Fed raising interest rates. We’ve already seen the effect this is having on companies like Celsius, which announced it was halting withdrawals, swaps, and transfers. Even industry leaders like Coinbase are struggling, with another round of layoffs being planned. What’s next for the crypto market? The Fed has signalled that it intends to continue raising interest rates throughout the year until inflation and demand are under control, meaning a further tightening of the economy and potential downward price action for crypto. However, it’s important to remember that the current sentiment won’t last forever and that, given enough time, the market should recover.
