How Will the Fed’s Rate Hike Affect the Crypto Market?

If nothing unexpected happens, the Federal Reserve is expected to release its interest rate decision on March 17 (Beijing time), and raising the federal benchmark interest rate is a high probability event.

In addition to the high US CPI in February, the conflict between Russia and Ukraine has also pushed up the prices of commodities such as energy and food, exacerbating the level of inflation. Global financial markets are paying close attention to the upcoming Federal Reserve interest rate meeting this week, and analysts generally predict that the interest rate will reach 2.5%.

Before the actual interest rate hike came, the Russia-Ukraine conflict became a major variable, which increased expectations for interest rate hikes and caused high volatility in financial markets.

Last week alone, gold prices soared to an all-time high of $2,060 an ounce; crude oil and commodities rose sharply; the crypto asset market fell after a brief rise to $45,800 on March 10, and the trend continued to be sluggish; although the U.S. stock market also rebounded strongly on the 10th, the Dow Jones Industrial Average, the S&P 500 and the Nasdaq still ended last week with losses.

The United States' monetary easing policy is about to end, and players in the financial market are eager to know how the Federal Reserve's interest rate hike will affect the stock market, crypto assets and other investments?

Greg McBride, chief financial analyst at Bankrate, a financial services provider, said that assets that have benefited the most from ultra-low interest rates in the past will be most vulnerable to a correction when interest rates rise, "such as high-growth stocks with good future returns and non-cash flow generating assets such as crypto assets."

Financial markets fell amid expectations of rate hikes

Although the Federal Reserve has not yet raised interest rates, the trend of tightening monetary policy is almost certain.

Data released by the U.S. Department of Labor on March 10 showed that the U.S. Consumer Price Index (CPI) in February soared 7.9% year-on-year, hitting a 40-year high. The average hourly wage adjusted for inflation in February fell 2.6% year-on-year, the largest drop since May last year, and it has fallen for 11 consecutive months. The soaring prices offset the increase in wages.

In such an inflationary environment, the Russian-Ukrainian war broke out in late February, pushing up commodity prices. International oil prices soared to $100 per barrel at the beginning of the conflict and reached $130 last week. At the same time, wheat futures prices soared from $8 per bushel to more than $12. The war has exacerbated concerns that global inflation will climb to higher levels.

To curb inflation, the Fed is ready to raise interest rates. In a previous US congressional hearing, Fed Chairman Powell said that the neutral interest rate could be between 2% and 2.5%, but it could also be higher. Financial analysis agencies, including CME's Fed Watch tool, expect the Fed to raise interest rates by 0.25 percentage points.

Under the expectation of high interest rates, financial markets have shown signs of a general decline.

Take the US stock market as an example. Many indexes still closed near their all-time highs last year. However, they have mostly fallen since then. Since the beginning of the year, the S&P 500 has fallen by about 12%, while the tech-heavy Nasdaq Composite has fallen even more, by 18%, and the Dow Jones Industrial Average has fallen by about 10%.

Caleb Tucker, director of portfolio strategy at Merit Financial Advisors in Atlanta, said, "The stock market is forward-looking, so expectations of rate hikes have already had an impact." Greg McBride, chief financial analyst at Bankrate, also said that starting in early 2022, the stock market began to retreat due to expectations that the Federal Reserve would raise interest rates to curb inflation.

Riskier investments have been particularly affected by expectations of rate hikes. High-growth technology stocks such as Cloudflare and Datadog have fallen by about 58% and 35% respectively from their 52-week highs a few months ago. Bitcoin, the mainstream asset in the crypto asset market, has fallen by about 44% from its all-time high in November last year, while Ethereum, the second largest asset by market value, has fallen by 49%.

With less money flowing through financial markets, this is a net deduction for overall investments. "Rising interest rates always trigger a period of stock market volatility," said Dan Raju, CEO of brokerage platform Tradier. "The fact that the Fed has indicated multiple rate hikes means we are in for a year of continued volatility."

But if the underlying economy remains strong, the volatility could also be short-lived, as strong economic fundamentals also lead to higher interest rates. "Historical data and trends for the Nasdaq, Dow and S&P 500 show that the market tends to recover in about three weeks," Raju said.

Will high interest rates be a disadvantage for crypto assets?

Whether it was inflation, low interest rates, lack of purchasing power, or a depreciating dollar, as long as crypto assets were rising, these positive factors could easily be misinterpreted as resilience, until the Russo-Ukrainian war shattered these illusions.

On February 24, the day when the Russia-Ukraine war broke out, the crypto asset market plummeted, and Bitcoin once fell to $34,222, with a daily drop of nearly 10%. Its labels of "digital gold" and "safe-haven asset" were deeply questioned, and its attributes as a "risky asset" became increasingly obvious.

"Crypto assets were once seen as an inflation hedge, but recently they have behaved more like other risk assets such as stocks," said Caleb Tucker, head of portfolio strategy at investment advisory firm Merit. "Going forward, higher interest rates will be a headwind for crypto assets."

Indeed, like other risk assets, cryptocurrencies have also reacted to reduced liquidity, falling in November when the Federal Reserve announced it would begin tapering its bond purchases and signaled that interest rates would soon rise.

Bitcoin S&P 500 falls before

As the chart above shows, Bitcoin started to fall before the S&P 500 and it does not hedge the index. In response to the Fed’s actions, Bitcoin started to fall in November before the S&P 500.

In the view of Greg McBride, chief financial analyst at Bankrate, assets that have benefited most from ultra-low interest rates in the past are most vulnerable to a correction in the context of rising interest rates, "such as high-growth stocks with good future returns and non-cash flow generating assets such as cryptocurrencies."

While Dan Raju, CEO of brokerage platform Tradier, acknowledged that crypto assets would certainly be adversely affected by higher interest rates, he expects gains for the year, “I firmly believe that crypto assets will be a net positive in 2022 as any short-term decline driven by rate hikes will be offset by greater adoption by both institutional and retail active traders.”

On March 14, Tesla founder Elon Musk tweeted that he still owns and "will not sell" his Bitcoin, Ethereum and Dogecoin, advising people not to hold US dollars when inflation is high. Last year, he added $1.5 billion of Bitcoin to Tesla's balance sheet, which caused a shock wave in the crypto world.

Ending quantitative easing will be the main tone of the US economic management department in 2022. The biggest question at present is how high interest rates may rise. This uncertainty itself has driven market volatility, and the answer still needs to be given by the Federal Reserve’s interest rate hike meeting this week.

Short-term investors will panic about high interest rates, increasing the likelihood of large market fluctuations, while long-term investors may see shocks and panic as an ideal opportunity to buy low. What if prices continue to plummet? Buffett once said some wisdom about this situation, "Opportunities rarely come, and when pie falls from the sky, catch it with a bucket, not a thimble."