Will a Possible Fed Loosening Help the Cryptocurrency Sector?

In a largely expected move, the Federal Reserve raised its benchmark short-term interest rate by three-quarters of a point, the fourth straight time it did so, according to the Associated Press. Representing the sixth rate hike this year, this framework on paper doesn’t help the cryptocurrency sector. After all, cryptos are basically pure risk-on assets. A hawkish monetary policy is anathema to such market categories.

Certainly, the backdrop presents even more forms of discouragement. According to the AP, the Fed’s “latest move raised its benchmark rate to a range of 3.75% to 4%, the highest level in 14 years. Its steady rate increases have already made it increasingly costly for consumers and businesses to borrow — for homes, autos and other purchases. And more hikes are almost surely coming.”

Again, that’s not great for cryptos. Yet the total market capitalization of all publicly traded blockchain assets has been on the rise since last Friday. Why?

According to a statement by the Federal Open Market Committee, “In determining the pace of future increases in the target range, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”

With higher rates having a pronounced effect on U.S. consumers – particularly in the housing market – it’s possible that the Fed could ease off the gas in terms of its monetary tightening initiative. Initially, the stock market on Wednesday popped higher on this rumor, although the major indices flashed red in the late afternoon session.

It begs the question, where will cryptos go from here?

Virtual Currencies Need Central Bank Support

While the blockchain-focused blogosphere lit up recently, with many proponents calling for the rise of cryptos, the wild ebb-and-flow in the stock market during the midweek session poured some cold water on this thesis. Nevertheless, the bigger point is that if cryptos were to rally again, it would need support from the Fed.

We’re not just talking about a reduction in hawkish intent. Rather, the central bank most likely needs to recreate the dovish environment that sparked the record run in cryptos throughout last year. It comes down to the incentivization profile of digital assets.

During a period of declining purchasing power, investors had every incentive to do something with their money. Otherwise, holding onto cash will effectively guarantee wealth erosion. So, if the inflation rate was say 2%, investors at minimum will need to park their cash in vehicles that will return 2% to break even.

Here’s where circumstances get tricky for “normal” investments and exciting for speculative assets like cryptos. The higher the rate of inflation, the greater the need for investing in higher-growth enterprises. With inflation hitting north of 8%, for instance, not too many reliable dividend stocks exist that provide such robust passive income to offset this implied currency erosion.

So, where do you turn? With inflation not only rising but also expanding at break-neck speed, the circumstances sparked an emotional response among investors. They had to do something – and right quick. Cryptos were at the right place at the right time, offering incredible returns with incredible ease.

However, if you took away the pressures and emotion of rapidly escalating inflation, would cryptos have jumped the way they did in 2021? Despite my personal belief in the sector’s long-term bullish narrative, I have some doubts.

A New Paradigm for Cryptos

When perusing various social forums focused on blockchain advocacy, you’ll often hear proponents discuss cyclical or seasonal concepts. For instance, because cryptos jumped higher after meeting a certain set of criteria in the past, once those same standards are “achieved” again in the (hopefully) near future, the sector should once again rise.

While anything’s possible when discussing cryptos, investors should ask a basic question: is the dog wagging its tail or is the tail wagging the dog?

Although a seemingly basic inquiry, it appears that crypto investors often overlook the core fundamentals in search of esoteric arguments. Primarily, cryptos originated around the early part of last decade. Significantly, between January 2010 through February 2020 (right before the COVID-19 pandemic), the Fed implemented a dovish monetary policy which broadly supported risk-on asset classes.

Specifically, the M2 money stock increased 53.5% during the aforementioned period. Now, from February 2020 through December 2021, the money stock expanded 28.5%. So of course cryptos spiked higher – the Fed incentivized the narrative.

However, between January and September of this year, the money stock suffered deflation to the tune of 5.64%. And with the Fed very much interested in controlling historically high inflation, this deflation will likely accelerate. Simply put, that’s fundamentally detrimental to pure risk-on assets like cryptos, meaning that investors should be very careful not to get too caught up with the blockchain resurgence hype.

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