Cryptocurrency prices have bounced after the tumultuous meltdown experienced last week. Most digital currencies like Cardano, Polygon, Bitcoin and Ethereum have jumped by more than 20% from their last week’s low. Bitcoin price has risen back to $40,000 while Ethereum is steadily approaching $3,000.
Why cryptocurrency prices crashed
Most analysts, myself included, have identified several reasons why cryptocurrency prices crashed last week. First, they dropped because of the fear of regulation from China and the United States. Indeed, after the recent Colonial Pipeline hack, the voices of tougher regulations in the US grew louder. A Wall Street Journal columnist also asked politicians to ban cryptocurrencies.
Second, Bitcoin prices dropped because of Environmental, Social, and Governance (ESG) impacts. The theory is that large institutional investors will avoid Bitcoin because of the carbon emitted during its mining. Obviously, this is baloney since more than 70% of all Bitcoins are mined using clean power. Also, fiat currencies are significantly dirtier than Bitcoin.
Third, there were concerns that Elon Musk would sell all Bitcoins Tesla owned. This is after he said that the company would stop accepting the currency because of its carbon emissions. As I noted then, this was pure hypocrisy since Tesla cars are also charged using fossil fuels.
Federal Reserve – The only game in town
In my opinion, cryptocurrency prices tanked last week because of the Federal Reserve. Let me explain. In its coronavirus pandemic response, the Fed decided to lower interest rates to zero and launch a major quantitative easing (QE) program. In it, the bank is printing $120 billion every month and channeling this money to the financial market through mortgage-backed securities (MBS) and Treasuries purchases.
By so doing, the bank has pushed the real bond yields to the negative zone, making it unprofitable for investors to buy bonds. As a result, many investors have channeled their deep liquidity to the stock market. Indeed, the main indices like the Nasdaq 100 and Dow Jones are hovering near their all-time high. Some of the extra liquidity has been channeled to riskier assets like cryptocurrencies and precious metals.
Therefore, with the labor market tightening, and with inflation rising, many investors believe that the conditions are ideal for the Fed to start tightening. Inflation has jumped to more than 4% while the number of people filing for jobless claims has dropped to the lowest level since the pandemic started.
As such, cryptocurrency prices declined because investors believed that the Fed will soon start hiking rates and tapering asset purchases. Indeed, as shown below, the decline of cryptocurrency prices coincided with the sharp decline of tech stocks, as shown by the Vanguard Growth ETF below.
The Fed is trapped
Last week, I explained how the Bitcoin price will react to the Fed tightening. In the article, I pointed out that the Bitcoin and other cryptocurrency prices will react angrily to any dovish tone. But I also warned that this reaction will be short-lived. While it is too early to tell, that happened last week during the sell-off.
However, in my view, I believe that the Fed is trapped and that it will struggle to hike interest rates. Close Fed watchers remember that the bank started hiking interest rates in 2015. It accelerated rate hikes in 2018 when it made four hikes. However, it was forced to slash rates three times in 2019 as markets tanked.
The situation will be worse this time and I believe that the bank is trapped. If the Fed hikes substantially, it will make servicing of US debt more expensive and slow the recovery. On the other hand, if the bank fails to tighten, it will incentivise more people and companies to borrow. Consider the statement below from an analyst:
“The Fed’s balance sheet keeps growing and the stock market keeps rising. Fearing a contractionary GDP effect from lower asset prices on future economic activity means the Fed may never be able to normalize interest rates,”
This will make it hard for the bank to tighten in the future. That will be a good thing for Bitcoin and other cryptocurrency prices.