The relationship between the US Federal Reserve interest rate and the Bitcoin exchange rate

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When considering the factors influencing the Bitcoin exchange rate, one in particular stands out: the key rate set by the US Federal Reserve. Understanding how this mechanism impacts the crypto market can help crypto investors make the right decisions.

The policy rate and what it affects

The US Federal Reserve policy rate is also described as the minimum interest rate at which commercial banks can borrow money from each other to meet the required level of reserves. By law, banks are required to maintain a certain level of reserves based on the deposits they have. When a bank has excess reserves, it has the right to lend them to other banks. Similarly, banks that run out of reserves can borrow money from other commercial organizations. The reserves themselves are stored in the Federal Reserve System – a kind of central bank, in other words. Several times a year, members of the US Federal Reserve Board meet and decide at what minimum rate commercial banks will be able to issue loans and borrow money from each other.

If the policy rate is reduced, the cost of money for business organizations is also effectively reduced. Depending on the policy rate, the interest rate on loans and deposits also decreases. Loans therefore become cheaper and deposits less profitable. If the interest rate increases, the cost of money to the bank increases. Indeed, contracting loans becomes less favourable, but the profitability of deposits increases.

The interest rate also affects the stock market. Indeed, a rise in the policy rate also leads to a rise in the yield of new Treasury bonds issued, while the value of bonds already issued at lower yields falls. For example, if the policy rate is 1.5%, then the government bond yield has traditionally been quite close to that level, say 2%. This means that the holder of these bonds receives an annual income of 2% from the bonds. If the key rate rises to 3%, new bonds are issued with a yield of around 3.5 to 4%. Meanwhile, the yield on bonds that were issued at the previous policy rate remains at 2%. As old bonds are less attractive in terms of profitability, their market value falls.

The key rate is indeed an instrument that has a direct impact on the country’s economy. The lower the policy rate, and therefore the cheaper the loans, the faster money moves through the economy; people’s purchasing power increases because they can take out cheaper loans from the bank, which means businesses can grow faster. Of course, the latter is usually not possible without a loan.

However, these advantages have a downside: cheap loans can increase inflation through excess aggregate demand. When inflation risks increase, the central bank may decide to raise the policy rate, making loans less affordable, reducing consumer demand for goods and slowing the growth of industry. This will certainly slow inflation, but will also lead to slower economic growth. Regulators around the world constantly conduct this balancing act, raising and lowering the policy rate according to economic indicators.

Bitcoin key rate and exchange rate

The link between Bitcoin and the level of the policy rate (in the United States) has intensified over the past five years, as US capital has become almost overwhelming in the crypto market. American investors – retail and institutional – have used cryptocurrency investments to maximize their return on investment. Even equities haven’t shown such growth, not to mention Treasuries (with their annual yield of less than 2%).

But, of course, there is one rule we forget. Diversifying an investment portfolio always assumes the presence of both high-risk (stocks, cryptocurrencies) and low-risk (bonds) assets. Indeed, if investors expect a rise in the key rate, then they expect a rise in the yield of low-risk bonds. This causes an outflow of capital from high-risk assets, including cryptocurrencies, and bonds already issued, the yield of which in the future will be lower than the yield of new bonds issued with an increased key rate. Part of the capital withdrawn will then be invested in new bonds with higher yields after the rise in key rates.

This happened at the turn of 2021/2022 when the US Federal Reserve announced the acceleration of the reduction of the economic stimulus program and the hikes in key rates planned for 2022. The first of these reports from the Fed appeared in November 2021. Then Bitcoin was trading at a level above $60,000. After reports of an impending rate hike, the cryptocurrency’s exchange rate began to decline, and in January the price fell below $40,000.

Mike McGlone, Bloomberg Chief Commodity Strategist called expectations of a rise in key rates a “hurdle” and a “headwind” for the Bitcoin exchange rate. However, his positive assessment of Bitcoin’s future remained unchanged with the words “Bitcoin has already proven its worth.”

“Above all, Bitcoin is not directly dependent on the policy rate. On the one hand, if market participants expect a rate hike, its rate is under pressure. But on the other hand, rising rates indicate that the regulator sees inflationary risks. , in recent years, has become in the eyes of American investors an alternative to gold, which is used to hedge inflation risks”, underlines Nikita Soshnikov, director at Alfacash. According to him, after every message about a possible acceleration of rate hikes (and there have already been several in the first quarter of 2022), the volume of Bitcoin sales on his platform increased by 25-30% compared to the average. daily.

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This post contains sponsored advertising content. This content is for informational purposes only and is not intended to be investment advice.

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