Has U.S. Federal Reserve policy turned the Cryptocurrency market bearish?

The total cryptocurrency market cap grew over 1000% in less than two years. How? Why?

Despite the worldwide corporate and retail adoption of digital assets, plus the innovation occurring within the field, our friends at the U.S. Federal Reserve (FED) are the primary reason underlying this exponential growth. Their loose monetary policy injected trillions of dollars into the financial system, debasing the currency against which all assets from real estate and luxury watches to food and lumber are measured. The ruler we use to measure prices is changing; that’s why nearly every asset class has effectively only gone up. Understanding why is critical for investors of all markets. This article looks at how we got here, what signals to watch going forward and whether U.S. Federal Reserve policy has helped to turn the cryptocurrency market bearish.

A rising tide lifts all boats

Despite the narrative that Bitcoin is an “inflation hedge,” Bitcoin more closely resembled a high-beta (more volatile) stock over the past two years. The price has appreciated hand-in-hand with growth stocks and has dropped alongside those same securities during sell-offs.

March 16th, 2020: The Federal Reserve announces its intention to purchase unlimited amounts of US government bonds and mortgage backed securities to "support smooth market functioning.” the beginning of this quantitative easing marked the exact bottom for stocks. To date, the S&P 500 has almost doubled in dollar-denominated value, and the total crypto market cap has added a zero.

Why did quantitative easing impact crypto markets? Well, buying bonds pushes bond yields down, forcing investors to leave bonds in search of higher returns. The combination of low interest rates and an expanding money supply led to a pathetic return of 0.50% on US 10-year government bonds. Investors know they can do better not too much further up the risk ladder.

Their capital moved from government bonds to corporate bonds, but that buying then pushed those yields down too! So, informed investors rotated from corporate bonds to dividend stocks, but that had the same yield-cutting effect, so they moved to growth stocks. This happened on and on and on up the risk ladder.

This process continued until investors stumbled into the highest risk and highest reward arena: crypto. And nearly everyone’s first encounter with the industry is through king corn, Bitcoin.

The flow of money from asset class to asset class propped up the prices of all investments, creating an “everything bubble.” Just look at how the four main asset classes have grown since the Federal Reserve started aggressively buying everything, and then look at the growth of the Fed balance sheet. The charts speak for themselves.

This risk-on behaviour is only one reason for Bitcoin's rally. In 2020, how many hundreds of millions of people were stuck at home with government money? The result? More Robinhood accounts - more Redditors’ in Wall Street Bets. Retail investors sliding into a pile of speculative investments, pushing the price of Bitcoin even higher.

The Bitcoin rallies of August 2020 and March 2021 showered confidence across everyone but the most critical of skeptics. Venture capital funds, hedge funds, and family offices began scaling the risk ladder well beyond Bitcoin into all digital assets, including altcoins, digital real estate, and NFTs. This created a massive bubble across the entire digital asset space that is, to date, still deflating.

Inflation is not your friend!

Many assert that Bitcoin is valuable because it acts as an inflation hedge in an environment of cheap money. After all, there are an infinite number of dollars, but only 21 million bitcoin. This is a common misconception - inflation and currency debasement are two sides of the same economic ruin, but they're not the same thing. Inflation is when prices rise with no regard for supply or demand. In contrast, dollar debasement is one currency’s loss of value relative to another. It's a semantic difference for this conversation, but something to keep in line. The bottom line, purchasing power is being eroded.

It's shocking how closely the past two years of price action across every market is correlated to the Fed's monetary policy. Viewing the S&P as a ratio to the money supply shows a return to pre-pandemic levels. The chart looks promising, but what's really happened is an injection of artificial demand. The market has become inefficient.

The reality is that Bitcoin trades more like a tech stock than an inflation hedge like gold or silver. Up until recently tech stocks have been outperforming the rest of the market. Stores of value have not. Ironically, the record-high inflation print on November 10th 2021 actually marked the top for Bitcoin almost exactly, and Bitcoin has fallen around 40% since. Despite the "inflation hedge" narrative, inflation may have ironically triggered the next Bitcoin bear market.

What to look for going forward

So is the bull run over? Are we in for two years of downwards momentum? The answers depend on the Fed's credibility, so the best we can do is theorize and prepare for any possible outcome.

Investors feared high inflation would lead to interest rate hikes and reduced quantitative easing, effectively ending the artificial demand. Fear caused the November correction.

The downside argument is valid. The Fed indicated they'll raise interest rates 25 basis points in March while decelerating monthly bond purchases in the January meeting. Less liquidity leads to expensive money, making existing debt more costly to maintain. This will cause the process that elevated every asset since 2020 to unwind. However, it's still unknown whether they'll actually follow through. The markets are downtrodden, and I wouldn't be surprised if the Fed changed their mind at the first signs of economic weakness or disfunction.

Let's look at 2018 for a second. The Fed announced a rate hike for December. The Nasdaq dropped 23% off the news. Just months later, they reversed the decision and markets fully recovered. Today's global economy seems more fragile than 2018's. The full economic repercussions of covid are still playing out, and there's no way to know how long it'll take.

It's possible the Fed can't raise rates without causing further meltdowns and tangible economic chaos. On top of this, U.S. government debt has reached an outrageous $30 trillion, meaning even a minor 1% increase in interest rates will cost the government billions of dollars in additional interest expense.

While the Federal Reserve is not a government institution, the U.S. political environment certainly impact their decision. Going into the midterm elections, the Biden administration will look to issue more cheap debt to fund future spending, and they'll want an all-time-high stock market to boost consumer confidence.

Personally, I doubt the feasibility of significant rate hikes this year, and I predict they will quickly walk back any profound changes they do end up making. The bubble may eventually burst but now's the wrong time. The economy is already on life support, and no politician worth their salt will risk reelection for the greater good.

The key factors to look for this year are the decisions around quantitative easing and the rate of economic recovery going into 2023. If the Fed intends to stop buying bonds and start unloading its $8 trillion balance sheet, all hell will break loose. Should that happen, we can expect a deep and prolonged bear market.

Economic growth is also a telling metric to watch because the Fed is more likely to prop up assets and keep interest rates low if the economy is slowing. This creates a counterintuitive relationship where a weak economy will actually help the market, not hurt it.

Whether or not the Fed’s aggressive monetary stimulus is just delaying an inevitable financial crisis is unclear, but it doesn't matter right now. As long as the music plays, you dancA rising tide lifts all boats

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I'm Paul

I am on a mission to help people start a journey to financial freedom. The key to long term success is education and understanding the incredible opportunity that exists right now.

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