Cryptocurrency prices seem to be less affected by macroeconomic factors than prices of more traditional financial assets. Key drivers for crypto assets include market confidence, adoption, technology and liquidity conditions (see Table)¹. By contrast, traditional financial assets are strongly influenced by macroeconomic drivers, such as interest rates and inflation. These traditional assets also differ from crypto in being subject to government regulations and in being more transparent in terms of know your-customer requirements and anti money laundering measures.
Table 1
Interconnections between the crypto ecosystem and macroeconomic factors show up in the fact that favorable market conditions increase investors’ appetite for higher risk assets, such as crypto currencies. Changes in interest rates and borrowing costs could impact crypto markets through different channels than for traditional assets. For example, financing costs influence venture capital firms’ decisions to invest in startups that want to build applications on blockchains (such as Ethereum), and consequently drive blockchain adoption. Likewise, for blockchains that lack an application layer and only have a transaction layer (such as Bitcoin), higher costs for financing mining rigs and warehouse space will lower marginal profits for miners. This difference is explained by the crypto assets’ different value proposition. Bitcoin’s value proposition is determined by transaction volumes and mining of these transactions, while Ether’s comes from transaction validation, and additionally through the utility of applications built on the Ethereum blockchain. Due to their short history and speculative nature, we acknowledge that existing trends may change. New trends might affect how macroeconomic factors impact the crypto ecosystem, especially as more retail and institutional investors expand their investment portfolios to include crypto.
The recent period of historically low interest rates fueled investors’ appetite for higher-yielding assets. The 2021 bull run in the crypto market coincided with a period of ultra-loose monetary conditions, eliciting the question of what impact, if any, low interest rates had on crypto valuations. By the same logic, as we are in a period of tighter monetary conditions, driven by higher interest rates and the reversal of Quantitative Easing (QE) – known commonly as Quantitative Tightening (QT) – it is of interest to understand the impact these dynamics will have. To better understand this relationship, we dove into the crypto ecosystem and analyzed the relationship with key macroeconomic factors using data through March 2023.
In this article we address the following questions:
1. Does monetary policy matter to crypto markets?
a. Do crypto prices correlate to changes in interest rates?
b. Do quantitative easing and tightening make a difference in cryptocurrency markets?
c. Is money supply important for the crypto ecosystem?
2. Does perception of a possible incoming recession matter for crypto markets?
3. Can crypto assets be a hedge against inflation?
4. What does a strong or weak dollar mean for crypto markets?
5. Do financial stress and market volatility spill over into the crypto ecosystem?
1. Does monetary policy matter to crypto markets?
The past decade appears to show that crypto markets perform well when there is fast growth in a broad measure of money supply (M2), stemming from a reduction in interest rates, quantitative easing and fiscal stimulus. Conversely, monetary tightening seems to have restricted appreciation of crypto assets, or even contributed to depreciation. In this section, we analyze how these relationships hold over time and focus on interest rates, and other monetary policy measures that influence money supply, such as quantitative easing.
A. Do crypto prices correlate with changes in interest rates?
The US Federal Reserve’s (Fed’s) actions influence the global economy, arguably including crypto markets. Low interest rates increase appetite for assets with higher risk and higher returns. In reaction to the decline in economic activity as a result of the Great Recession (2007-2009), the Fed and other central banks lowered interest rates to zero and held them at that level for just shy of a decade. During that period, demand for higher-yielding assets, including speculative grade credit was very strong. Global high yield issuance increased from less than $50 billion in 2009 to more than $250 billion in 2014. This demand for higher-yielding assets could also have extended to crypto assets.
Conversely, when the Fed, and other major central banks increase benchmark interest rates, higher-yielding assets become less attractive. It could be argued that the same applies to crypto assets. We analyze whether this inverse relationship between interest rates and crypto prices is supported by the data.
We use the risk-neutral yield on the 2-year US Treasury bond to gauge short-term market expectations on the evolution of US interest rates – it reflects what markets are pricing in for the Fed funds rates two years from today, according to the ACM model developed by the Fed. To study the crypto markets, we use the S&P Cryptocurrency Broad Digital Market Index (S&P BDMI). We focus our analysis on data from February 2017 (when the index started) to March 2023. In some cases, we look at longer time periods and will use Bitcoin prices.
The S&P Cryptocurrency Broad Digital Market Index (S&P BDMI) reflects a broad investable universe of digital assets listed on open digital exchanges. Assets have to meet minimum liquidity and market capitalization criteria. Lukka is the pricing provider. The index is weighted by the equivalent of market capitalization for cryptocurrencies (coin supply multiplied by coin price). Bitcoin represents 40% of S&P BDMI, so the index is highly correlated with Bitcoin prices.
In Chart 1, we plot S&P BDMI and the 2-year Risk-Neutral Treasury Yield. Since 2017, the two indices exhibit a historical correlation of –0.33.
