How will the Federal Reserve's interest rate hike affect the cryptocurrency market?

Author: Jasmine, Hive Tech

As expected, the Federal Reserve is anticipated to announce its interest rate decision on March 17 (Beijing time), with an increase in the federal benchmark interest rate becoming a high-probability event.

In addition to the high U.S. CPI in February, the conflict between Russia and Ukraine has also driven up the prices of energy, food, and other commodities, exacerbating inflation levels. Global financial markets are closely watching the upcoming Federal Reserve meeting this week, with analysts generally predicting that interest rates will reach 2.5%.

Before the actual rate hike arrives, the Russia-Ukraine conflict has become a significant variable, raising expectations for rate increases and causing high volatility in financial markets.

Just last week, gold prices soared to a historic high of $2060 per ounce; crude oil and commodity prices surged; the cryptocurrency market briefly rose to $45800 on March 10 before retreating, continuing its sluggish trend; despite a strong rebound in the U.S. stock market on the 10th, the Dow, S&P 500, and Nasdaq still ended the week lower.

The U.S. monetary easing policy is about to end, and players in the financial markets are eager to know how the Federal Reserve's rate hikes will affect the stock market, cryptocurrencies, and other investments.

Greg McBride, chief financial analyst at financial services firm Bankrate, stated that assets that benefited the most from ultra-low interest rates will be the most susceptible to corrections as rates rise, "such as high-growth stocks and cryptocurrencies that do not generate cash flow."

Financial Markets Decline Under Rate Hike Expectations

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

Data released by the U.S. Department of Labor on March 10 showed that the consumer price index (CPI) in the U.S. surged 7.9% year-on-year in February, reaching a 40-year high. Meanwhile, the average hourly wage adjusted for inflation fell 2.6% year-on-year, marking the largest decline since May of last year, and has decreased for 11 consecutive months. The soaring prices have offset wage growth.

In such an inflationary environment, the Russia-Ukraine war broke out in late February, driving 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 surged from $8 per bushel to over $12. The war has heightened concerns about global inflation reaching even higher levels.

To curb inflation, the Federal Reserve's rate hike is "imminent." In a previous U.S. Congressional hearing, Federal Reserve Chairman Jerome Powell stated that the neutral interest rate could be between 2% and 2.5%, but it could also be higher. Financial analysis institutions, including CME's FedWatch tool, expect the Federal Reserve to raise rates by 0.25 percentage points.

Under high rate hike expectations, financial markets have already shown a tendency to decline.

For example, in the U.S. stock market, several indices were still close to historical highs at the end of last year. However, since then, they have mostly been on a downward trend, with the S&P 500 index down about 12% since the beginning of the year, while the tech-heavy Nasdaq Composite index has fallen even more, by 18%, and the Dow Jones Industrial Average has decreased by about 10%.

Caleb Tucker, head of portfolio strategy at Merit Financial Advisors in the Atlanta area, stated, "The stock market is forward-looking, so the expectations of rate hikes have already had an impact." Greg McBride from Bankrate also noted that the stock market began to decline in early 2022 due to expectations that the Federal Reserve would raise rates to curb inflation.

Higher-risk investments have been particularly affected by rate hike expectations. High-growth tech stocks like Cloudflare and Datadog have fallen approximately 58% and 35% from their 52-week highs a few months ago, respectively. Meanwhile, the mainstream cryptocurrency Bitcoin has dropped about 44% from its historical high last November, and the second-largest cryptocurrency, Ethereum, has fallen by 49%.

The reduction in liquidity in the financial markets is a net detriment to overall investments. "Rising interest rates will always trigger a period of stock market volatility," said Dan Raju, CEO of brokerage platform Tradier, "The fact that the Federal Reserve has indicated multiple rate hikes means we will experience a year of sustained volatility."

However, if the underlying economy remains strong, the volatility may be short-lived, as strong economic fundamentals can also lead to rising interest rates. "Historical data and trends for the Nasdaq, Dow, and S&P 500 indices suggest that the market often recovers within about three weeks," Raju said.

Will High Rates Become a Disadvantage for Cryptocurrencies?

Whether it is inflation, low interest rates, lack of purchasing power, or dollar depreciation, as long as cryptocurrencies are rising, these positive factors can easily be misinterpreted as resilience until the Russia-Ukraine war shattered these illusions.

On February 24, the day the Russia-Ukraine war broke out, the cryptocurrency market plummeted, with Bitcoin briefly dropping to $34,222, a nearly 10% decline within the day, casting doubt on its labels of "digital gold" and "safe-haven asset," making its "risk asset" nature increasingly apparent.

"Cryptocurrencies were once seen as a hedge against inflation, but recently their behavior has been more like other risk assets such as stocks," said Caleb Tucker, head of portfolio strategy at investment consulting firm Merit, "In the future, higher interest rates will pose a disadvantage to cryptocurrencies."

In fact, like other risk assets, cryptocurrencies have also reacted to reduced liquidity. Last November, when the Federal Reserve announced it would begin tapering bond purchases and hinted that interest rates would rise soon, cryptocurrencies also fell.

As shown in the above image, Bitcoin began to decline before the S&P 500 index; it does not hedge against that index. In response to the Federal Reserve's actions, Bitcoin started to decline in November, ahead of the S&P 500 index.

According to Greg McBride, chief financial analyst at Bankrate, assets that benefited the most from ultra-low interest rates are the most susceptible to corrections in the context of rising rates, "such as high-growth stocks and cryptocurrencies that do not generate cash flow."

Although Dan Raju, CEO of brokerage platform Tradier, acknowledged that cryptocurrencies will certainly be adversely affected by higher interest rates, he expects them to rise this year, "I firmly believe that cryptocurrencies will be a net positive in 2022, as any short-term declines driven by rate hikes will be offset by greater adoption from institutional and retail active traders."

On March 14, Tesla founder Elon Musk tweeted that he still holds and "will not sell" his Bitcoin, Ethereum, and Dogecoin, advising people not to hold dollars during high inflation. Last year, he added $1.5 billion in Bitcoin to Tesla's balance sheet, creating a ripple effect in the crypto world.

Ending quantitative easing will be the main tone for the U.S. economic management department in 2022. The biggest question now is how high interest rates might rise, and this uncertainty itself is driving market volatility, with answers still needed from the Federal Reserve's rate hike meeting this week.

Short-term investors may panic over high rates, increasing the likelihood of significant market volatility, while long-term investors may view the shocks and panic as ideal opportunities to buy at low prices. What if prices continue to plummet? Buffett has shared some wisdom on this situation, "Opportunities are rare; when a pie falls from the sky, you should catch it with a bucket, not with a thimble."