How Interest Rate Changes Impact the Cryptocurrency Market

The US Federal Reserve's key interest rate decisions have a wide-reaching impact, influencing global markets, including cryptocurrencies like Bitcoin.

Interest rate decisions by the Federal Reserve (ἮΠΑ) have a wide-reaching impact on global markets, including cryptocurrencies like Bitcoin. Being a relatively new and volatile asset class, crypto markets react dynamically to rate hikes and cuts. As the central bank shifts its monetary policy stance, it causes ripples in the demand, volatility, and liquidity of cryptocurrencies, which investors need to monitor carefully.

Let’s take a closer look at how interest rates affect cryptocurrencies and the role they play in the crypto market.

How Interest Rates Affect Cryptocurrency

Interest rate hikes and cuts impact the cryptocurrency market differently, mainly depending on investor sentiment and the broader economic context. Rate cuts tend to fuel optimism as it increases liquidity in the market, leading to higher risk-taking and increased demand for speculative assets like Bitcoin. Conversely, rate hikes tend to reduce liquidity, making riskier assets less attractive.

Let’s take a closer look at the two scenarios — rate hikes and rate cuts — and their different impacts on the crypto market.

What Happens During Rate Cuts?

A central bank or Fed's decision to cut rates is usually a sign that the economy is weakening. When the Fed cuts rates, borrowing becomes cheaper, which tends to encourage risky investments, including cryptocurrencies.

For instance, in 2020, when the Fed cut rates by 0.25%, Bitcoin initially experienced a 60% correction, followed by a remarkable 1,600% surge throughout the year. Lower interest rates tend to drive investors away from traditional savings vehicles toward more speculative assets like cryptocurrencies. Bitcoin, in particular, benefits as a safe-haven asset during inflation fears, especially when those fears coincide with falling interest rates.

A research report by S&P Global supports this thesis by emphasizing the pronounced correlation between Bitcoin price fluctuations and monetary policy adjustments. Indeed, periods of low interest rates are associated with rising prices, while rapid rate hikes lead to declines, reflecting broader market trends.

Why Rate Hikes Trigger Declines in Crypto

On the other hand, rising interest rates have the opposite effect. As Cointelegraph notes, rising interest rates squeeze liquidity in financial markets, making risky assets like cryptocurrencies less attractive. Rising rates increase yields on low-risk fixed income instruments, prompting investors to pull capital out of volatile assets like Bitcoin.

Cryptocurrencies have responded to the decrease in liquidity like other risk assets: they fell when the Fed announced its intention to raise rates in November 2021 and then throughout 2022 when the Fed aggressively followed through on its promise. In addition, the collapse of cryptocurrencies such as LUNA / UST, and exchanges like FTX has undermined traders' confidence in these virtual assets. Bitcoin's price fell about 65% at the time.

Markets are currently consolidating as the pace of rate cuts and the health of the US economy remain unclear.

Bitcoin is actively moving on expectations: while the markets were expecting a rate hike, Bitcoin was falling, but as soon as the Fed stopped raising rates, the markets started pricing in a rate cut, which caused the price to rise.

At the moment, the markets are consolidating since the speed of the rate cut and the state of the US economy are not entirely clear. But as the Fed begins to ease its monetary policy after a period of tightening, a rise in Bitcoin’s price seems inevitable, however, in the short term, it may still go into a correction.

Thus, when the economy is expected to improve, risky asset classes like equities and crypto are also expected to rise together, driven by positive investor sentiment and increased liquidity. However, when rates rise mainly due to monetary policy tightening to combat inflation, the cost of capital increases. As a result, risk-on assets like Bitcoin lose their appeal, causing their value to fall as rates continue to rise.

Other Factors

Apart from the federal funds rate, several other factors can influence the performance of cryptocurrencies, including the broader macroeconomic climate, institutional interest, and regulatory changes. Here are a few key points to consider:

US Treasuries

Cryptocurrency was often advertised as a panacea for all problems, be it inflation, low interest rates, lack of purchasing power, or the devaluation of the US dollar. These positives were easy to believe, while cryptocurrency was growing seemingly independently of other assets.

It is interesting to look at the correlation between Bitcoin's price and the yield curve spread between 10-year US Treasuries and 2-year Treasuries. Divergences between the assets lead to a corresponding correction in Bitcoin's price.

As far as we know, when short-term US bonds become more profitable than long-term ones, this is called an inversion of the yield curve. Under normal circumstances, long-term bonds offer higher yields, as investors focus more on riskier assets, such as Bitcoin, 2-year bonds, stocks, etc in the short term. However, when the yield curve inverts, i.e. when