How Fed's Rate Hike affects Crypto Market Sentiment

This year has been awfully eventful for bitcoin and the entire crypto market which has maintained a steep fall since topping out in November 2021. Aside from the bearish technical market outlook; global economic macros — particularly the continuous Fed rate hike have contributed heavily to the direction of the market, thanks to rising inflation and unemployment rate.

As long as inflation continues to climb, the Fed will be obliged to hike rates on a regular basis, causing the bears to bite harder. But why does the Federal Reserve need to hike interest rates, and how do interest rate decisions affect the entire crypto market? This piece dives deep into the underlying economics and its correlation with the crypto market.

The Federal Reserve plays a huge role in keeping the economy stable. Its mission is to keep inflation under control and to enable the job market to flourish as much as feasible. With inflation reaching dangerously high levels in 2022, the Fed is facing one of its most difficult problems in decades.

The Fed's primary instrument for managing inflation is its ability to influence interest rates. Based on what it sees in the economy, the Fed can hike or drop its benchmark rate, known as the federal funds rate. The federal funds rate affects how much banks and other financial entities pay to borrow, which in turn affects businesses and individuals.

Low-interest rates stimulate the economy by lowering the cost for firms and consumers to invest in new projects, hire additional employees, or take out loans to purchase expensive assets like houses or vehicles. Higher rates have the opposite effect, slowing the economy by depressing consumer demand.

Taking the 2022 scenario as a whole, there has been a run in the rising consumer price index (CPI) throughout the year, with the CPI for August now standing at 8.3 percent higher than the previous year. In response to this series of events, the Fed has continued to raise rates in order to lower the purchasing power of institutions and individuals thereby attempting to strike a balance between supply and demand which will, in turn, have a ripple effect on the inflation rate.

Strong rate hikes are not good for cryptocurrency prices, and experts anticipate that price volatility will likely continue in the near term as the Fed struggles to stabilize the economy. While the consequence should halt rising prices, the slowing economy will bite into corporate earnings and market sentiment.

This negative sentiment does not end with Wall Street. It seeps into the crypto market as risk aversion rises in response to the deterioration of the economy. It's not usually a direct correlation at all times, but we've been seeing this pattern over the last few months. 

Since the beginning of 2022, risky assets such as stocks and cryptocurrency have been strongly correlated. Both have been moving in tandem this year, with investors fleeing in reaction to increasing interest rates, growing inflation, and the possibility of a recession. If the stock market falls as a result of another rate rise, the crypto market would most certainly fall as well – and vice versa.

We've already seen the crypto market suffer because investors are wary of investing in high-risk assets like crypto. While cryptocurrencies have already shown to be an excellent store of wealth in the face of deteriorating economic conditions, the inherent danger of these assets, as well as their volatility, is making investors increasingly skeptical.

Investors' dwindling sentiment could be seen in the just concluded Ethereum Merge, which turned out to be a non-event despite being touted as the largest upgrade in the existence of Ethereum.

Indeed, it is believed that the pandemic cash transfer spree contributed to the spike in cryptocurrency prices around the end of 2020 and early 2021. People had cash to spend, and they did so. Fast forward two years, and we're now dealing with the aftermath. In the United States, inflation peaked at 9.1% in June, rising at the fastest rate in four decades.

Experts believe that future interest rate hikes will severely constrain the US economy, which has endured two straight quarters of negative GDP this year and is either in or on the edge of a recession. As a result, if the Fed continues to tighten monetary policy during its September meeting and beyond, the cryptocurrency market would respond unfavorably and could set new lows for 2022. However, this does not imply that investors should substantially alter their long-term crypto investment plan.

One of the most significant inflation numbers was the May inflation rate released on June 11, which saw the consumer price index (CPI) rise by 8.6% in May from a year ago, the highest increase since December 1981. This inflation figure prompted the Fed to raise interest rates by 75 basis points (bps) to a range of 1.5% to 1.75%, its highest rate hike for a single meeting since 1994.

Bitcoin took a massive hit, falling sharply from the $30k level reached the previous week to touch new lows below $18k. Ether, the second most valuable crypto asset, and other altcoins lost considerable value, ranging from -30% to more than -50%, with many traders comparing the apocalypse to the March 2020 covid crash.

The main concern right now is how high will interest rates go given how quickly they have been climbing in 2022. Long-term investors may consider it the perfect moment to acquire certain high-quality investments at low costs since the crypto economy is supported by strong fundamentals in the long term. After all, history has shown that the biggest winners in the bull market are those who dived deep into the market when everything came crashing with market sentiment at its lowest.

As Warren Buffet will always say, “Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble.”