The Federal Reserve’s (Fed’s) prime rate is the lending rate at which banks lend to each other for short periods of time. If a bank needs to transfer or “cash out” funds to a customer, but its reserves are insufficient, then it borrows capital from another financial institution for a short period of time at a minimum interest rate.
The Fed’s prime rate is the main instrument of monetary policy in the United States. Changes in the prime rate have a significant impact on the financial system, the stock market, and are reflected in the value of various asset classes, including bitcoin and cryptocurrencies.
Historical data shows an inverse relationship between the Fed’s prime rate and bitcoin prices: a decline in the Fed’s rate increases the capitalization of bitcoin and other digital assets, and vice versa.
How are the Fed’s prime rate and risk level related?
Every financial asset has a certain level of risk. From a macroeconomic perspective, assets are divided into two basic types:
- Risky assets are instruments with floating returns that depend on investor behavior and market dynamics and conditions. Risky assets include stocks of public companies. Bitcoin does not yet have a clear status, but behaves as a volatile and high-risk asset, whose price movements coincide with the dynamics of the stock market.
- Low-risk or protective assets have low yields but generally stable prices. They act as a means of preserving value during economic downturns. These assets include certain fiat currencies, precious metals (particularly gold), and highly-rated government and corporate bonds. In addition, higher rates lead to higher yields on U.S. government bonds, which are the main crisis asset in the world.
Why does the price of bitcoin change when the Fed hikes the rate?
During a period of economic growth, the Fed keeps the prime rate low – this encourages investment and lowers the overall savings rate. Since high-risk assets have higher return potential, they are more popular with investors.
When there is an economic recession or crisis, the Fed raises the prime rate. This encourages economic agents to increase their savings, sell high-risk assets, and go into “safe haven,” that is, to invest in conservative instruments with increasing returns.
As the Fed’s prime rate rises, banks raise interest rates on loans to individuals and businesses, and investments become more expensive. This slows the economy in all areas, and demand for goods, services, and other components of any economy falls.
Over-tightening or not stopping the rate hike in time can lead to a recession, not only in the U.S., but also in other countries at the expense of the dollar’s supremacy in the world economy.
In such a tough environment, investors tend to choose assets with predictable yields like government bonds rather than risky unpredictable assets, which include bitcoin.
The Fed Funds rate is an important, but not determining factor in the price of cryptocurrency. You should not make decisions based solely on that parameter.
Who considers bitcoin a risky asset and why?
While some investors see bitcoin as “digital gold,” that is, as a means to save value, others pay more attention to its high volatility.
Grayscale experts categorized bitcoin as a high-risk asset back in early 2022, highlighting its long-term uptrend ahead of gold and the cryptocurrency’s high volatility as a good opportunity for speculation.
In April, analysts at Arcane Research said the correlation between the price of bitcoin and the Nasdaq Composite Index, which reflects the value of the U.S. technology sector, had peaked. Tech stocks are considered a volatile “growth asset.”
In early June 2022, Bloomberg Intelligence exchange-traded commodities strategist Mike McGlone also drew parallels between the decline in the crypto market and the “great pullback” in prices of high-risk assets during the 2008 and 1987 crises. While McGlone expects the first cryptocurrency to acquire the status of a savings vehicle, he now classifies bitcoin as a risky asset.
According to Kaiko, by June 2022, bitcoin had reached its maximum correlation with the leading S&P 500 and Nasdaq 100 stock indices, which also indicates its volatile, high-risk nature.
The first cryptocurrency does not always correlate with risky assets. In 2020, experts at fund manager VanEck Global recorded a record correlation between bitcoin and gold. In 2021, Katie Wood, head of ARK Investment Management, said that big business sees bitcoin as a tool to protect against dollar inflation. A prime example of this approach is MicroStrategy, which holds some capital in the first cryptocurrency.
What happens to the price of bitcoin when the Fed eases policy?
When the Fed lowers its rate, it starts buying assets on the open market, injecting liquidity into the system. There is more money, credit is cheaper, and the investment climate improves. All of this accelerates economic growth, allowing businesses and citizens to access cheaper money through low interest rates.
Soft policies and more cheap money encourage investors to lower their risk requirements and invest in new technology, development, construction, startups, funds, and other risky instruments, including cryptocurrencies.
Another tool the Fed can use is so-called quantitative easing. It was first used in the 2008 crisis. Then the Fed by increasing its own monetary balance through the printing press began to buy up the U.S. market unreliable securities and bonds of large companies that were experiencing financial difficulties.
Thus, the regulator supported the economy and avoided mass defaults. Although quantitative easing led to a sharp increase in the money supply and higher risks of inflation.
Soon after, the bitcoin network began to work, which was a response to the problems in the financial system and the actions of the authorities.
The Fed applied quantitative easing again, but on a much larger scale, in the spring of 2020, when the United States declared a lockdown because of the coronavirus pandemic.
From March to June 2020, the Fed pumped nearly $3 trillion into the economy. This not only stopped the decline of the stock market, but also triggered a rapid growth of prices for high-risk assets. The cryptocurrency market began to grow at the same time.
However, this growth cycle ended with a sharp increase in dollar inflation caused by the Fed’s actions, which had a negative impact on the price of bitcoin.
Will bitcoin remain a risky asset?
There is no exact answer, but in the past, researchers have repeatedly documented the correlation between bitcoin and gold, a traditional defensive asset.
According to Dan Morehead, founder of U.S. crypto fund Pantera Capital, the Fed is excessively manipulating the market by buying more and more distressed assets, which has already led to problems in the labor, government bond and mortgage markets in the United States. Problems in the U.S. economy will inevitably affect the rest of the world.
Morehead believes that bitcoin’s only problem is the increased correlation with high-risk assets, particularly with the S&P 500 Index during its downturns. The financier believes this situation is not something permanent.
Morehead is convinced that sooner or later the paths of cryptocurrencies and traditional assets will finally diverge.