Wu said in depth: The impact of the US monetary policy shift on cryptocurrencies

Wu Shuo Author | Liu Quankai

Editor of this issue | Colin Wu

In simple terms, loose monetary policy, on the one hand, has led to a continuous increase in the amount of funds in the entire society; on the other hand, it has led to the depreciation of legal currency. Investors have more funds in their hands, and for the purpose of protecting their assets, they have sought means of preserving or increasing the value of their assets beyond the inflation rate, and have continuously spread their funds to various financial markets. Whether as a myth of wealth creation or as a powerful means to fight hard inflation, Bitcoin has attracted a large number of retail investors and institutions to participate, allowing this immature market to move towards a new climax with the continuous influx of incremental funds and the continuous saturation of existing funds.

2020.1-2021.5 US M1 and M2 money stock (Billions of Dollars) (Data source: FRED official website)

However, the carnival is over, and the 80/20 rule is still in effect. Bitcoin prices have plummeted from their peak, and most investors have paid back the money they earned in the bull market, and even lost their principal. The myth of institutional entry has also been shattered, and some listed companies have been mocked as "big leeks" for buying at high points. Market trading volume continues to be sluggish, and the divergence between longs and shorts has significantly intensified. In this uncertain market, it is worth reviewing the fundamentals that have previously driven the cryptocurrency market up.

This article re-focuses on the loose monetary policy of the United States, and explores the impact on the cryptocurrency market through the background, transmission path, and changes of monetary policy implementation. Through analysis, the author believes that the fundamentals of monetary policy before and after the crypto market are quietly changing subtly. In the future, the United States will inevitably embark on the path of raising interest rates, which leads to the potential impact that future tight monetary policy may have on the cryptocurrency market.

1 Background of the implementation of the US quantitative easing monetary policy

1. Economic development was damaged by the epidemic

On the eve of the outbreak, the quarterly growth rate of US GDP (gross domestic product) remained at around 2%. When the epidemic broke out in 2020, US GDP fell sharply, reaching an astonishing -9.033% growth in the second quarter. Under the impact of the epidemic, the two major driving forces of US economic growth, the level of household consumption and domestic capital investment, were severely suppressed. Then around March 2020, the Federal Reserve began to implement a substantial quantitative easing policy, saving the market by signing a rescue plan and frantically "throwing money" into the market in order to promote consumption and investment. The US economy has improved, and GDP has begun to transform from negative growth to positive growth.

2018.1-2021.3 US real GDP: year-on-year: seasonally adjusted (data source: CEIC official website)

2. Severe unemployment rate

At the beginning of the epidemic, the U.S. unemployment rate remained below 4%. From January 1948 to March 2021, the average unemployment rate in the United States was 5.6%. After the full outbreak of the epidemic, the unemployment rate in the United States soared to 14.8% in April 2020, which was the highest value in history since the observation of data. It gradually fell in subsequent months, but as of March 2021, the unemployment rate was still higher than the historical average. The high unemployment rate has made the impact of this epidemic crisis on the U.S. domestic economy greater than ever before.

U.S. unemployment rate from December 2019 to March 2021 (data source: CEIC official website)

3. Maintaining the federal funds rate at 0-0.25% for a long time

As the US government failed to effectively control the epidemic, the US economy and financial markets fell into recession due to the epidemic. In March 2020, the US lowered the federal funds rate to zero and maintained the federal funds rate at a low range of 0-0.25% for a long time. The effective space for the traditional monetary policy that uses interest rates as an intermediate target tool has basically been lost.

2017.6-2021.6 U.S. effective federal funds rate (Percent) (Data source: FRED official website)

In summary, the monetary policy background of the United States implementing quantitative easing can be summarized as follows:

1. The epidemic has been unable to be brought under control, domestic consumption and investment are sluggish, and the US economy is in recession;

2. Unemployment soared, the public panicked, and expectations were damaged;

3. Traditional dovish monetary policy has failed.

Based on this situation, in order to reverse the downward trend, the United States implemented an open quantitative easing monetary policy, by repurchasing medium- and long-term bonds such as treasury bonds without setting a quota, in order to maintain the smooth operation of the market and ensure the effective transmission of monetary policy. It can also be simply understood as indirectly printing more money and injecting a large amount of liquidity into the market, so it is jokingly called "unlimited QE" by investors.

The cryptocurrency market, led by Bitcoin, is prospering further in such a macro context, moving towards new peaks step by step.

2 The transmission mechanism of the US loose monetary policy affecting cryptocurrencies

1. Exchange rate transmission

Since March 2020, the United States has implemented an open quantitative easing monetary policy, injecting a large amount of liquidity into the market. As the world currency, the U.S. dollar has inevitably depreciated as the supply of U.S. dollars has increased significantly and the demand for U.S. dollars has remained almost unchanged.

2019.11-2021.6 US Dollar Index DXY (data source: Trading View)

As the number one rival of the U.S. economy, China has been the first to effectively control the domestic epidemic, resume work and production effectively, and China's economy has recovered rapidly. The renminbi is appreciating against the U.S. dollar, so the renminbi-dollar exchange rate is facing great appreciation pressure. If Bitcoin is regarded as a currency, it can be compared to the renminbi mentioned above. Bitcoin is negatively correlated with legal currency. In the context of legal currency depreciation, the Bitcoin-dollar exchange rate will maintain an upward trend. Therefore, in the wave of economic globalization, the profit-seeking nature of capital will inevitably cause the outflow of U.S. dollars, and a considerable part of the "hot money" will flow to countries or markets with better investment returns. In addition, the nominal wealth of U.S. residents has increased due to quantitative easing monetary policy, and a considerable part of the funds will flow into the cryptocurrency market (mainly Bitcoin), which will in turn affect the price of Bitcoin.

In general, the exchange rate transmission mechanism of the US quantitative easing monetary policy to the cryptocurrency market can be as follows:

1. The United States implements a quantitative easing monetary policy, which increases the dollar base currency, increases the dollar money supply, and increases the residents' book wealth (nominal wealth);

2. The liquidity of the US dollar increases, and the fluctuation of the US dollar exchange rate shows a depreciating trend;

3. “Hot money” flows into the cryptocurrency market, led by Bitcoin, which has a good return on investment;

4. Incremental funds are pouring in, existing funds are growing, the price of Bitcoin is rising, and the exchange rate against the US dollar is on an upward trend.

The transmission path of the exchange rate of the US quantitative easing monetary policy affecting the cryptocurrency market (Image source: Wu said blockchain production)

2. International capital flows

In order to cope with the impact of the epidemic on the domestic economy, developed countries such as the United States, Japan and Western Europe have adopted quantitative easing policies, injected a large amount of liquidity into the global economy, and formed a large amount of short-term international mobile capital. These short-term international mobile capitals pursue high-return financial products to obtain rich investment returns, with obvious speculative and arbitrage characteristics.

Bitcoin has experienced more than ten years of development. In addition, the cryptocurrency market has become more active in 2020 due to the prosperity of DeFi and can still maintain a relatively high rate of return on investment. Therefore, the cryptocurrency market led by Bitcoin has become one of the main markets for international capital to pursue speculative returns during the period of quantitative easing monetary policy by investors in major developed economies.

3. Expected monetary tightening

Observability of the US Monetary Policy Shift

1. The U.S. economy is gradually recovering

Although the US GDP was hit hard in 2020, the US economy is gradually recovering after implementing multiple rounds of quantitative easing monetary policies. As can be seen from Figure 1, the US GDP growth rate is gradually rising, and as of the first quarter of 2021, the US GDP has returned to positive growth. The two major driving forces of US economic growth, household consumption and capital investment, have both returned to a relatively high level.

U.S. private consumption expenditure from December 2019 to March 2021 (US$ billion) and U.S. overseas investment portfolio from December 2019 to December 2020 (US$ million) (data source: CEIC official website)

2. Unemployment rate expected to improve

The CEIC official website predicts that the US unemployment rate is expected to return to below the historical average in 2022. The gradual reduction in the unemployment rate is an important support for economic recovery.

Forecasted unemployment rate in the United States from December 2019 to December 2026 (data source: CEIC official website)

3. Inflation expectations are solidified, and interest rate hikes are inevitable

The Consumer Price Index (CPI) is an index that measures the changes in the overall price level in the market. Generally, market economies believe that the CPI is within an acceptable range of 2%-3%. Since the United States implemented quantitative easing monetary policy in March 2020, its impact has produced negative feedback in 2021. Entering 2021, the CPI has been rising steadily, and in May 2021, the US CPI increased by 4.9% year-on-year.

Growth of the US Consumer Price Index (CPI) from December 2019 to May 2021 (data source: CEIC official website)

In May 2021, the US Producer Price Index (PPI) increased by 6.5% year-on-year, while it increased by 6.1% year-on-year in the previous month. The accelerated rise in the US Producer Price Index has undoubtedly further exacerbated inflationary pressure.

Figure 10 Growth of the US Producer Price Index (PPI) from December 2019 to May 2021 (data source: CEIC official website)

In addition, indicators such as the 10-year U.S. Treasury bond and the commodity price index all point to the high inflation the United States is currently facing. Adjustments to the federal funds rate, i.e. rate hikes, are inevitable, and monetary policy will also turn to tightening.

In Fred's forecast, it is expected that the Federal Open Market Committee (FOMC) will raise the federal funds rate, that is, raise interest rates, starting in 2022, and the median federal funds rate will reach 0.6%.

FOMC Federal Funds Rate Median Economic Forecast Summary (Percent) (Data source: FRED official website)

1. Funds may flee in large quantities in the short term

As mentioned in the international capital flows, investors from various countries have turned to the speculative, high-return cryptocurrency market to avoid the negative impact of the country's quantitative easing monetary policy, injecting a large amount of liquidity into cryptocurrencies such as Bitcoin. However, with the current economic recovery of developed economies, the funds originally deposited in the cryptocurrency market may flee in large quantities in the short term, leading to a reversal of market capital flows. The flow, stock and direction of these "hot money" will have a profound impact on the cryptocurrency market, thereby affecting the trend of Bitcoin prices.

The author believes that in the current cryptocurrency market, there are signs of capital outflow.

2. "Herd effect", large capital withdrawal causes panic

The author believes that the shift in US monetary policy and when it will shift has already caused a certain degree of psychological concern in the cryptocurrency market. Once upon a time, investors are now paying close attention to some US economic meetings that may be big or small and have little or no short-term impact. This actually reflects concerns about monetary policy, because high inflation has made investors aware that interest rate hikes are inevitable. Once it is announced exactly when to raise interest rates or when to tighten more clearly, it will not only affect the flow of short-term capital "hot money" in the international market, but also affect the capital situation in the market and the psychological expectations of investors. If large funds from large institutions or large companies choose to withdraw, market panic will spread further, further affecting the price of Bitcoin.

The transmission path of the tightening of US monetary policy to the capital flow in the cryptocurrency market (Image source: Wu said blockchain production)

(III) The possible long-term deflation will bring about the real healthy development of the cryptocurrency market

One of the obvious drawbacks of the crazy influx of funds is that the market is flooded with excessive "leek plates" and "Ponzi schemes". During the period when Meme tokens were crazy, a large amount of funds flowed in, and many investors speculated on various animal tokens with the dream of getting rich overnight. Of course, there are good works among them, but more of them are a mess after the craze. The increase in market liquidity has also increased the craze of investors, allowing project owners to find more ways to cut leeks.

Some macroeconomists believe that the United States may achieve monetary tightening in the next decade. If monetary policy turns to long-term deflation to reverse high inflation, the funds flowing into the market will decrease, and there will be a situation of outflow of existing funds and separatism. Based on such conditions, it is possible that the project tokens in the cryptocurrency market will pay more attention to the value of products and users, and the development of the cryptocurrency market may be healthier. At the same time, under the condition of healthy development, it will attract off-market funds to enter the market for layout.