The crypto market has exhibited close negative correlation with interest rate expectations over the last couple of months with a narrative taking hold that rising interest rates are bearish for crypto. However, the fundamental justification for this narrative is weak.
The first point to consider is that historically crypto has correlated positively with interest rate expectations. As the chart shows, an increase in the 10-year US Treasury yields coincided with a rise in the price of bitcoin (BTC) until November 2021, when the relationship reversed.
When the crypto market was dominated by retail investors, macroeconomic factors had little impact on the direction of the market, and there was no observable correlation with interest rates and bond yields. The institutionalisation of crypto can be dated back to roughly 2020, and we can see that during this period and until November 2021, bitcoin traded broadly in line with 10-year yields. This indicated that institutional investors regarded bitcoin an inflation hedge.
In November 2021, the narrative suddenly changed to inflation being a risk to crypto. The question: is an inflationary, rising interest rate environment bullish or bearish for crypto?
What is the rationale for the narrative “rising rates are bad for crypto” and what merit do these explanations have?
The explanations for why rising rates should affect cryptocurrencies negatively do not really hold up. We look into the reasons why:
“Higher-yielding currencies attract investment flows away from lower-yielding currencies. Therefore, higher fiat interest rates will drive fund flows from cryptocurrencies into fiat.”
Real interest rates (nominal interest minus inflation) are currently strongly negative with the last CPI print at 7.5 percent (which arguably understates actual inflation), and current Fed funds rate at 0.25 percent. With a 1.25 to 1.75 percent tightening expected this year and inflation expected to remain at 6 percent, real negative rates would increase from minus 7.25 percent to about minus 4.5 percent at best. It is possible that a slightly higher current income may influence some investors, but fixed income assets at negative real interest rates are value destroying.
In addition, rising bond yields mean a bear market in bonds, and until and unless inflation falls significantly (which is not expected over the next year), bond yields have a long way to rise before positive real yields are in sight.
“Non-interest bearing assets (such as gold but also cryptocurrencies) do badly in a high or rising-interest-rate environment.”
Aside from the fact that many cryptocurrencies now offer income in the form of staking yields, the above has only held true for gold in the case of high real interest rates. It mostly has to do with the fact that high real rates usually signify a stable macroeconomic and monetary environment, reducing the demand for safe haven assets.
Rising nominal interest rates have not been associated with bear markets in gold.
Disinflationary assets such as gold (or cryptocurrencies) have been used primarily as stores of value and de facto hedges against macroeconomic instability. The price of safe haven assets strongly correlates with the perceived stability of the financial system. The gold price rallied during the 1930s, the “stagflationary” 1970s, and since the 2000s, as the macro stresses have become increasingly apparent. Since the start of the current crisis in March 2020, bitcoin has taken over from gold as the primary destination of safe haven asset flows.
The Fed losing control of the inflation narrative over the past year is one sign of the instability in the system. The Fed first claimed inflation would not exceed the targeted 2 percent, then that it would but only slightly, then that it is running much higher, but this is only transitory. Finally, they have admitted that inflation is high, not just transitory, and they need to adjust policy accordingly. Other signs of instability include the unprecedented increase in the money supply over the last two years, unsustainable levels of government and private sector debt and increasing geopolitical tensions. These are precisely the scenarios when investors should, and do, turn to safe haven assets.
“Assets whose value is based on growth and cashflows far in the future do badly in a rising interest rate environment because the discount rate used to value those cashflows is higher.”
Although this may apply to decentralised applications (such as DeFi) built on blockchain platforms as these projects can earn revenues in a similar way to companies, it seldom applies to cryptocurrencies.
Cryptocurrencies are valued in part as currencies (based on the size of the economy they support and their velocity), in part as stores of value (akin to precious metals), and in part as a transaction fee economy that derives its value from the applications building on it. Valuing cryptocurrencies such as bitcoin typically is not done on the basis of forecasting future cashflows and discounting them.
“In a rising interest rate environment, the price of riskier (more volatile) assets falls because investors retreat into less-volatile assets.”
Risk-off behaviour is common when risk perception is elevated, although perception of the environmental risk may not equate to an actual rise in risk as measured by volatility. (Increased volatility in risk assets is associated more often with a flat or inverted yield curve than with rising interest rates, and the US dollar yield curve has been flattening since March 2021.)
Additionally, while fixed income assets are less risky (less volatile), in an environment of inflation and rising rates, they experience price declines, while assets with underlying growth trends offset the value erosion from inflation.
A kneejerk risk-off reaction tends to evolve over time into a more nuanced assessment of the risks and opportunities.
Interest rates are not the only market driver
The crypto market is supported by the very strong growth in user adoption and a proliferation of applications building on the blockchain. Some of this growth comes from decentralised projects taking market share from traditional corporations.
Against a backdrop of historically extremely stretched valuations for equities, credit and bonds (i.e. negative real yields), the crypto asset class stands out with a strong underlying growth trend, as the new economy takes market share from the old economy.
Meanwhile, crypto has the beginnings of its own interest rate market, where rates are set by market forces not by central banks.
Will crypto continue to trade down as rates rise?
While this narrative has dominated over the last couple of months, the fundamentals mostly do not justify it. Narratives that take hold have a self-fulfilling aspect with market participants reacting because they expect others to react. However, over time reality always asserts itself.
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About Sygnum
Sygnum is the world’s first digital asset bank, and a digital asset specialist with global reach. With Sygnum Bank AG’s Swiss banking licence, as well as Sygnum Pte Ltd’s capital markets services (CMS) licence in Singapore, Sygnum empowers institutional and private qualified investors, corporates, banks, and other financial institutions to invest in the digital asset economy with complete trust. Sygnum operates an independently controlled, scalable, and future-proof regulated banking platform. Our interdisciplinary team of banking, investment, and Distributed Ledger Technology (DLT) experts is shaping the development of a trusted digital asset ecosystem. The company is founded on Swiss and Singapore heritage and operates globally. To learn more about Sygnum, please visit www.sygnum.com.
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