The Federal Funds Rate and Crypto

We’ve come a long way in the evolution of cryptocurrency. Since the minting of Bitcoin’s Genesis Block, crypto quickly gained a “wild west” reputation. With no real precedent to refer to, regulators were dumbfounded at how to proceed. However, as the technology progressed and the culture and audience expanded, it became increasingly clear that guardrails were long overdue. Regulation was unavoidable for crypto to be taken seriously and become a legitimate financial market.

This is the first concept to digest before we unpack theFederal Funds Rate (Fed rate) and its impact on crypto. The cryptocurrency markets are rapidly becoming intertwined with legacy financial sectors like stocks, bonds, and fiat currencies. With billions of dollars pouring in from spectators, hedge funds, and corporations, it’s safe to say that factors like the Fed rate indirectly affect the crypto space as well.

Understanding the Federal Funds Rate

The Fed rate may be simple to understand, but its weight and magnitude cannot be overstated. It could potentially be one of the threads that tie all financial markets together. 

Fed rate refers to the rate of interest banks use when they lend money to each other. The Federal Reserve sets this rate and can adjust it in response to market conditions. 

On that note, as global inflation persists as a hot-button issue, things like Federal Reserve practices and the Fed rate are becoming more crucial for retail spectators and even non-participants to understand. Much like the way a crypto network is designed with a series of nodes communicating in unison, banks around the world work together in one big financial network.

For example, when a major change happens in the U.S., it has the potential to reverberate throughout the global banking system. The resulting market movements are reflected across the global economy. 

The Federal Funds Rate acts like a financial dam

In essence, the Fed rate operates like a modern dam system. This dam restricts monetary lending, allowing just enough to flow out to keep the economy moving. The flow adds to the liquidity of surrounding financial markets. 

If the Federal Reserve ever chose to, they could open the dam, flooding everything it connects to. In practice, this system is designed to allow for cheaper lending during economic hardships to help businesses and individuals stay afloat.

How does the Fed rate affect financial markets?

It’s been said that stock charts do not represent market movements, but rather, human emotions. All financial markets are undermined by the human element. When rapid action is taking place on a chart, many of these bids and asks can be attributed to the feelings and opinions spectators have at that moment. 

If you see cracks forming on your local water dam, you may begin to panic thinking that it is about to collapse. Likewise, whenever the Fed announces that it is adjusting the rates, superstitious analysts and spectators can potentially take this as a sign that the sky is falling. Any resulting sell-offs, or buying action, can snowball into a massive price movement.

The tangible effects of Fed rates

Spectators follow the Fed rate because it can potentially be a signal of which direction stocks, bonds, currencies, and other financial instruments may trend. We’ve discussed the psychological effects of Fed rate changes, but what about the true, measurable effects? 

What is it about the Fed rate adjustments that cause visible reactions in the market?

Lending rates encourage market movement. When rates are low, more lending is happening throughout the economy. Typically, we see more home loans, new businesses, and general industry boom when the Fed rate is low. When money starts to move, more people may feel encouraged to enter speculative markets like stocks and bonds. 

Source: https://ofdollarsanddata.com/ 

The above chart shows how traders may initially react to Fed rate changes. This movement was in direct response to March 3, 2020, Federal Reserve announcement of an emergency 0.5% cut to the federal funds rate. The S&P 500 is one of the most renowned stock market indexes. 

Do Fed rate changes affect crypto as well? 

The days of cryptocurrency being removed from the fluctuations of legacy markets appear to be long over. All arguments to the contrary must be disregarded as the crypto space has risen and fallen in tandem with stocks and other assets over the past few years.

The past Fed rate meetings of 2022 have seemingly led to reactive volatility in these sectors, with Bitcoin’s price undergoing strong movements following meetings held in March, May, and June.

At CEX.IO, we aim to be a guide for our users, and as a result, we have followed these events closely throughout the past year, most notably in our weekly crypto ecosystem updates. 

In the above chart, we can see momentum occurring after Federal Reserve meetings in May and June regarding the Fed rate, among other issues. 

The most recent Fed rate change occurred towards the end of July, though not enough time has passed to deduce what effect it may have had. It’s important to note that these adjustments to the Fed rate are likely one piece of a larger picture for market spectators, and cannot be considered the sole cause of these bullish and bearish moves. 

However, these moments may act as a signal of sorts for traders. To learn more about these potential signals and indicators, visit CEX.IO University to continue your crypto education. 

Crypto’s image is changing as it is embraced by traditional finance

The narrative surrounding cryptocurrency is hastily being rewritten. Its sordid reputation has been rebranded as that of a promising new technology that is revolutionizing countless industries. 

This new facade has been met with an influx of capital and media attention, as well as new crypto-backed financial products.

However, while the days of the “crypto wild west” may be coming to an end, there is certainly still plenty of volatility for traders to appreciate in the current landscape. The Fed rate is only one metric that can potentially catapult BTC in a new direction. Any bullish or bearish momentum in stocks or forex currencies from any number of economic reasons can simultaneously whip crypto traders into a frenzy. 

The future of crypto as a major financial market 

After fighting against crypto for the better part of the last decade, it’s clear that the world of major finance is now embracing it. Slowly but surely, the crypto space is being taken seriously. This opens up a plethora of possible avenues for traders and retail spectators as more crypto-related financial instruments are introduced. 

The stage is now set for crypto to be implemented in ways that are more akin to traditional finance. 

Exchange traded funds (ETFs) have been heavily advocated by the crypto community, and there are finally several available options such as the ProShares Bitcoin Strategy ETF (BITO), or the Valkyrie Bitcoin Strategy ETF (BTF). 

Further down the line, we could witness the birth of Bitcoin-backed retirement funds, crypto SPX funds, and countless other products. In an homage to cyberpunks of the past, more and more theoretical concepts are becoming reality. 

However, with these benefits comes responsibility and regulation. Major cryptocurrencies like Bitcoin and Ethereum could potentially begin to behave less like parabolic rockets and more like the ebb and flow of ocean tides as their infamous volatility is tamed over time. 

The Fed rate and other traditional factors may help to steer this market in the future as opposed to the rampant and thin speculation that has plagued this space for the last decade. 

In the above chart, you can see a comparison of the ProShares Bitcoin Strategy ETF (BITO), S&P 500, and Ethereum (ETH). The three have traveled an undeniably similar path throughout the past year. 

Should we expect more Fed rate adjustments soon? 

The global economy is experiencing a tumultuous period. Issues such as currency inflation, changing job markets, and the housing crisis have put stress on the Fed rate dam, and it’s likely that future calibrations are coming as a result. 

Thus far in 2022, we have witnessed four rate adjustments. As if testing the waters, the first change of +25 basis points (0.25-0.5%) this past March was comparatively minor. Each following adjustment has been increasingly larger, with this past July bringing an adjustment of +75 basis points (2.25-2.5%.) 

The Inflation Reduction Act 

We can look to recent developments to get an idea if future Fed rate adjustments are in order. Just this past month, the US Senate passed a 755-page bill aimed at combating inflation by tackling issues endemic to health care, taxes, and climate change. 

Analysts that have reviewed the bill extensively have declared that while it may ultimately reduce inflation in the future, it paradoxically may increase it through 2024. 

With the concern of rising inflation and other economic perils lingering, like the burgeoning recession, many spectators believe that we could potentially see another Fed rate adjustment this month, even before the next scheduled Federal Reserve meeting in September. 

While this is on the table, the only thing that is assured is that traders and market analysts will be waiting on the sidelines to see what momentum and direction the next Fed rate announcement could bring.