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Amid the chaos on the crypto market, new investors have been entering the market in search for profitable speculative opportunities. On the other hand, long-term crypto holders have endured difficult market conditions, with eyes on lower interest rates in the coming years to offset some of the damage and stimulate the markets.
In fact, many crypto traders and investors also speculate the currency markets to hedge against their underperforming crypto holdings when major monetary policy changes are taking place. You can learn more about the basics of the currency markets here.
But how exactly does a changing interest rate affect the performance of the crypto market and specifically - Bitcoin? - To answer this question, we must look at the basic effects of interest rate hikes and cuts and assess the degree of which the crypto market may be susceptible to such changes when compared to the bond and stock markets.
Why Interest Rate Changes Are Important
The interest rate is the primary tool of the central bank of a particular country to guide the monetary policy in the economy and affect borrowing costs to combat inflation. For example, when inflation is high, central banks typically hike interest rates - making it more expensive to borrow from banks and somewhat slowing economic growth.
Conversely, low rates boost borrowing and consumption, leading to higher growth figures, while carrying inflation risk.
Therefore, when interest rates are low, all investors need is for the returns of the stock and crypto markets to be higher than the inflation and interest rates to generate consistent profits, which boosts speculative trading on both markets. On the other hand, higher rates make the bond market more attractive for investors, which leads to them taking liquidity out of the crypto and stock markets and into bonds.
Understanding this simple principle is key in timing when to enter the crypto market and when to diversify your investment capital into fixed-income securities to hedge against volatility on the crypto and stock markets.
The Effect of Interest Rates on the Cryptocurrency Market
When central banks choose to hike interest rates, borrowing for speculative purposes tends to be the first to take a hit. Therefore, traders who benefited from low interest rate loans and were able to pay the interest using their trading returns, become less likely to do so as interest rates rise, as their returns must also rise to justify borrowing for trading.
For this reason, rapid spikes in borrowing costs directly affects the performance of the crypto market, particularly when it comes to meme coins and other speculative instruments.
For instance, the likes of DOGE, SHIB, PEPE, and other meme coins are highly likely to drop considerably lower than BTC and ETH during such periods, which further elevates the risk associated with speculating on their prices.
In many cases, traders may try to boost their returns using derivatives, such as options and futures, which further increases the risk profile of their trading strategy.
For this reason, industry insiders typically do not advise beginners to trade options and futures, as the downside risk is also enhanced with such trades.
Trading Bitcoin as Digital Gold
An interesting outlier has emerged over the past years, with traders and investors treating Bitcoin as digital gold, which means that investors actually buy more Bitcoin during market uncertainty and higher interest rates, as traders speculate less on altcoins and direct more of their attention towards BTC.
Therefore, the effects of interest rate changes may be less apparent on the price of Bitcoin, as opposed to altcoins, which tend to be much more volatile.
That being said, the actual qualities of BTC as an investment are still considerably different when compared to gold and many are reluctant to treat Bitcoin as a safe haven asset, due to its inherent price instability.
Furthermore, the effects of BTC price changes also has an outsized impact on the rest of the market. For instance, when Bitcoin falls by 5%, multiple altcoins may fall by 10-15%, or more.
This further highlights the dominance of BTC on the global crypto market and the issue of diversification among crypto investors, which is further complicated by the interest rate changes in recent years.
