Crypto Investors Need to Carefully Watch the $1 Trillion Mark

Following the seemingly relentless interest rate hikes that the Federal Reserve imposed on the monetary system in 2022, the cryptocurrency market suffered a dramatic erosion of market value. It represented the antithesis of the go-go cycle of 2021, when the central bank’s main priority was avoiding an economic meltdown due to COVID-19. However, with pandemic fears fading, the Fed has a different objective: controlling inflation.

Unfortunately, no major action occurs in a vacuum and Fed Chair Jerome Powell understands this better than anyone. After reviewing encouraging data that the pace of inflation was conspicuously slowing, policymakers decided to whittle down the magnitude of benchmark rate hikes. In turn, risk-on assets such as cryptocurrencies and growth-oriented stocks bounced substantially higher on a year-to-date basis.

Nevertheless, the latest data suggests that the party may be slowing, especially for cryptos. As the Motley Fool recently noted, the digital asset market fell amid a number of distracting events. First, the U.S. Securities and Exchange Commission is investigating crypto exchange Kraken for violating securities laws. Second, Coinbase (COIN) CEO Brian Armstrong remarked that regulators may be targeting the practice of crypto staking next.

Further, Craig Erlam, an analyst at broker Oanda remarked that the benchmark crypto appears to have entered a correction phase. “It was never just going to go from strength to strength and this correction will enable us to see just how quickly money pours back in. It should be an interesting couple of weeks.”

Currently, the total market capitalization of all cryptos stands just above the $1 trillion level. For investors to have confidence that this year’s rally can hold for the short and intermediate term, it must maintain this psychologically important threshold. Otherwise, losing this stronghold would invite the bears to crash the party (literally).

For Cryptos, It’s All About the Fed

To be sure, not everything about the downward price action of cryptos represents a negative. Aside from giving speculators sitting on the sidelines a chance to buy in at lower rates, the mechanisms of crypto mining may inspire the bulls to jump back in.

To make a long story short, several blockchain networks feature a self-intelligent mining-difficulty protocol. As more miners participate in the network (increased demand), mining difficulty rises, thus facilitating the net impact of preventing runaway inflation due to excess coin/token creation. If miners leave the network (reduced demand), then mining difficulty declines to effectively incentivize participation.

Undoubtedly, it’s a remarkable characteristic of the blockchain innovation. At the same time, investor demand is everything for risk-on assets like cryptos. Given the pressing fundamental challenges of the moment, no guarantees exist that the virtual currency complex will maintain its hold on the $1 trillion mark.

Primarily, everything points back to the Fed. Setting aside price targets, the fact is that between late 2014 to late 2022, the benchmark crypto and the real M2 money stock shared an 87.81% correlation coefficient. As money stock increased (inflation), cryptos rose. As money stock decreased (deflation), cryptos fell.

It’s not a perfect one-to-one relationship, obviously. However, digital asset investors ignore the correlation at their own risk, in my opinion. While the latest distractions don’t help the cause for cryptos, the main driver for sector valuations arguably is the Fed. Basically, it always has been.

Certainly, the relationship can change. Past performance doesn’t guarantee a repeat performance, to paraphrase the common investment disclosure. Still, the circumstances right now could be even worse for cryptos, not better.

Yes, inflation can always come back again. In particular, with China reopening, increased economic activity implies greater resource consumption. This could lead to a dramatic spike in energy prices. So, inflation should be a positive for cryptos, right?

Perhaps in most cases, yes. However, because interest rates are so elevated, the health of the consumer and investor are worse off now than two years ago. That’s why I’m not particularly gung-ho about cryptos at this juncture.

We’ve Been Here Before

Another factor that prevents a wholly optimistic view about cryptos in the near-to-intermediate term is the frequent head fakes that cryptos often generate. As with any other popular asset class, cryptos never rise perfectly during bull markets, nor do they fall perfectly during bear markets. Often, price action temporarily materializes that contradict the prevailing trend.

That could be what we’re seeing with the overall rally of the year so far. When the crypto complex melted down in 2018 following a dramatic lift in the prior year, plenty of head fakes printed themselves on the chart before market valuations eventually fell to their lows.

Plus, when cryptos enter a genuine correction cycle, it’s not just a one-year event. Combined with the challenging fundamentals of the day, investors should be cautious about digital assets right now.

• Crypto Recovery in January 2022
• Should Investors Worry About Insider Selling for Nvidia (NVDA)?
• Unusual Options Volume for Bit Mining (BTCM) Both Compels and Concerns
• 3 Factors to Watch as Investors Gauge the Cryptocurrency Market in 2023