Overview
- Introduction
- Monetary Policy: ELI5
- Why is Monetary Policy an Important Macro Theme?
- A Brief History of the Crypto-Macro Interplay
- The Role of Inflation and Economic Growth
- Summary
Introduction
The maturation of cryptocurrency as an asset class in its own right and the entrance of institutional investors means that the prices of large-caps like Bitcoin and Ethereum are becoming ever more intertwined with wider financial markets.
Rising correlations with the S&P 500 (which tracks the stock performance of 500 large companies listed on exchanges in the United States) weren’t observed until 2020, as shown in the chart below. More than ever, the price growth of stocks and cryptocurrencies remains highly correlated, reaching the highest level ever in May 2022.
Whether this correlation persists is yet to be seen, but the association between cryptocurrencies and stock markets means that the fundamentals and events that affect the stock market are likely to move crypto markets as well.
The macro picture is increasingly becoming relevant to cryptocurrencies as the market grows to a significant size. While still tiny compared to other financial markets, it’s become increasingly difficult to ignore and throw off as a fad. But what exactly do we mean when we’re talking about macro?
Macro refers to the macroeconomic trends, such as economic growth, inflation, interest rates, employment rates, and geopolitics, on a country and global level. Macro traders express their views using stocks, bonds, currencies, and commodities.
The important thing is that the main drivers in these markets are fundamentals. One of the best examples is the divergence in interest rates, where an investor goes long and buys a currency where the interest rates are rising and sells a currency where the interest rates are falling or remaining steady at a very low level.
A recent example that highlights this idea in action is the rise of USD-JPY, where the USD has gained on JPY because of rising rates in the US and a commitment to a loose monetary policy in Japan.
Just like the traders in the commodities, equity and forex markets must keep their finger on the pulse of macro events, so too it’s becoming important for crypto traders. As a major driver of financial markets, the key macro indicators are related to monetary policy, which refers to the trends in interest rates, inflation, economic growth, and geopolitical events.
Let’s first dive into monetary policy and how this macro driver has been affecting the crypto market in recent times.
Monetary Policy: ELI5
Monetary policy refers to the use of interest rates, changes in the money supply, as well as quantitative easing (QE) or quantitative tightening (QT) to influence the economy. The federal funds rate, which is the baseline for interest rates in the US, determines the rate at which businesses and consumers are charged for loans, as well as the return that savers will earn on their capital.
The Fed decides on interest rates eight times a year, where the Federal Open Market Committee (FOMC) gauges economic data to make these decisions. It’s good to know when these meetings are so you can prepare yourself in advance, where you can find all the upcoming FOMC meetings using this calendar.
And since the outcomes of these meetings and accompanying press statements usually have the highest impact out of all macro events on financial markets, there is a lot of volatility around the time of these announcements.
As displayed below, since 2020 the intraday volatility has been higher by almost 40% for BTC on days of monetary policy statements, while for ETH, the intraday volatility is almost 12% higher than compared to all other days.
To decipher the statements and meeting minutes (which are released around one month after the interest rate announcements and statements but have less of an impact), it’s important to understand the following two terms:
- Hawkish: when the economy is performing well and policymakers want to hike interest rates to temper inflation, this is described as hawkish.
- Dovish: when the economy is struggling and policymakers are leaning towards cutting interest rates to boost the economy, this is described as dovish.
When Fed officials deliver speeches, traders will look at how hawkish or dovish Fed officials are to determine the future path of interest rates, the economy and how this may impact financial markets in the near future.
Why is Monetary Policy an Important Macro Theme?
Monetary policy is also one of the most important determinants for the strength of a country’s currency, given that the rate of interest also influences capital flows and the strength of its currency. For the years following the global financial crisis in 2008, interest rates have been very close to zero.
As the economy crashed, the US central bank eased conditions (the Federal Reserve or the Fed for short) to stimulate demand and growth, where a lower rate of interest provides a lower cost of borrowing for consumption and investment by individuals and businesses.
In short, interest rates are used as a lever to influence demand, and in turn, inflation and economic growth. We can see from the chart below that interest rate cuts occur during recessions to boost demand when conditions are deteriorating. However, when the economy is growing, there’s scope to increase rates to ensure that the economy doesn’t become overheated, demand outstrips the supply side and inflation runs rampant.
The way monetary policy affects the economy is shown in the diagram below, known as the monetary policy transmission mechanism.
Most importantly, for crypto investors, changes in the official rate affect the market value of securities, such as equities.
This is because the expected future returns are discounted by a larger factor, so the present value of any given future income stream falls. Also, because investors can earn more on their USD from interest-bearing assets, such as US Treasury bonds, the relative attractiveness of these risk-off assets increases and reduces the appetite for risky assets like equities and cryptocurrencies.
On the other hand, lower interest rates stimulate asset prices as it becomes less attractive to save dollars or buy bonds, since the return is not as high as it could be with cryptocurrencies or equities.
Changes in the official interest rate work to increase or decrease the value of a country’s currency. When interest rates are falling, this provides a boost to exports as the currency will become weaker (through reduced capital flows and outflows from USD) but also acts to increase asset prices, such as stocks, real estate, commodities like gold, and cryptocurrencies like bitcoin.
As well as equities and the value of the US Dollar itself, interest rates also affect the price of bonds. Rising interest rates lower bond prices and vice versa for a fall in interest rates. A bond is essentially a loan to a government that pays a guaranteed return, and is viewed as one of the safest assets.
For example, 10-year US Treasury yields are a widely observed indicator in global markets, since they reflect economic prospects and drive global financial conditions. High rates are associated with tighter financial conditions, while low or even negative yields contribute to looser global financial conditions - leads to the “search for yield” effect, which drives up asset prices and may also encourage greater risk taking - which is generally thought to be positive for cryptocurrencies as an asset class.
A Brief History of the Crypto-Macro Interplay
As we’ve shown above, throughout the entire existence of Bitcoin and Ethereum, the base interest rate in the US has remained very close to zero. There’s a zero lower bound, since it’s not feasible for interest rates to be below zero. With the existence of cash, a central bank is unable to enforce a negative deposit rate, since people would simply take their money out of their bank accounts and park it in cash.
But negative interest rates have already been considered as a potential tool for monetary policy in the future, which would be possible with a ban on cash and the introduction of Central Bank Digital Currencies. These are future developments to look out for that may affect crypto and is one of the main bullish theses.
To provide a more accommodative environment after the global financial crisis in 2008, the Fed and other major central banks introduced quantitative easing instead of reducing interest rates below zero, which ballooned the size of these central bank’s balance sheets in relation to the size of their economies.
The cryptocurrency market exploded in value across 2016 and 2017, while interest rates were rising but were still very low by historical standards. But as interest rates in the US went above 1%, crypto markets entered a bear market, after valuations had overextended, and investors exited in favor of safer assets.
The Fed tried to reverse QE during 2018, but failed to do so without spooking the market (including crypto) and is only now talking once again about QT. QT refers to the unwinding of the Fed’s support for financial markets, i.e., selling the massive amount of mortgage-backed securities and US Treasuries on the Fed’s balance sheet.
Nevertheless, cryptocurrency was still very much in its development stage at this time and the chart below shows that as cryptocurrency as an asset class has gained more legitimacy and matured, Bitcoin’s market cap rose rapidly in response to the large increase in the USD money supply during 2020.
In response to the Covid-19 pandemic and the freefall in financial markets during March 2020, there was an emergency rate cut to bring interest rates back to the zero lower bound and was accompanied by a dramatic increase in the size of the Fed’s balance sheet.
During the Covid-19 pandemic and following policy response of slashing interest rates to near zero, 10-year yields turned negative. Because the Fed purchased Treasury securities through the QE program, this put downward pressure on yields to support financial conditions and lower longer-term interest rates to stimulate the economy.
Similar to the case mentioned before where the interest rate differential between US and Japan has been driving price action in USD-JPY, the divergence between money supply growth for cryptocurrencies like Bitcoin and Ethereum is increasingly being seen as a major driver of crypto price action over the long term. Traditional macro investors like Paul Tudor Jones popularized this fundamental theme following the massive stimulus and commitment to unlimited monetary support from the Fed following the Covid-19 pandemic.
But as the growth in the money supply has tapered off and as the Fed has committed more to reversing QE, a program which has supported financial markets for so long, we’ve recently seen a decline in the annual growth of Bitcoin’s market capitalization and the entire cryptocurrency market taking a hit.
But what is the potential future path of interest rates in the US and what are the implications for crypto? To answer this question, we have to examine trends in economic growth and inflation.
The Role of Inflation and Economic Growth
The mandate of most central banks, including the Fed, is to maintain a stable but low price level in general across the economy. Low and stable rates of inflation are desirable as investors and consumers can plan for the future, knowing that prices will not change rapidly, and have confidence in the future, which supports economic growth.
Therefore, inflation readings can help traders gauge how interest rates may evolve in the future and the most important measure of inflation for the Fed is the Consumer Price Index (or CPI for short). The CPI data is released every month (between the 10th and 15th), and often has a high impact on financial markets, including stocks, bonds, and more recently cryptocurrency. The CPI data releases can be tracked on calendars, such as this one from FXStreet.
If inflation rises over target or is coming in higher than expected, this suggests the central bank may take more action to prevent the economy from overheating by raising interest rates. Because of rapidly rising inflation in the past year, the CPI readings have had more and more of a bearing on the cryptocurrency market, as this data plays a huge part in the formation of monetary policy.
But also, as mentioned previously, there’s a divergence between the money supply growth as well as inflation for fiat currencies like the US Dollar and cryptos like Bitcoin and Ethereum. With inflation running at 40-year highs, the Fed is forced to raise rates, which negatively affects the macro case for cryptocurrencies. As rates rise, inflation should eventually fall, which reduces the need for an inflation hedge.
However, once it is clear that inflation has peaked, then the Fed will become less aggressive with rate hikes and we should see a softening in their stance, as economic growth comes into focus. As rates rise, not only does it bring inflation under control, but it also acts as a drag on growth. Borrowing for investment and consumption becomes more expensive, exports become less competitive and debt becomes more expensive to service.
As well as their mandate to target low and stable inflation, another responsibility of the US central bank is ensuring full employment. On the one hand, central banks like the Fed need to balance inflation and manage expectations such that prices do not get out of control. But on the other hand, they cannot continue to raise rates to stamp out inflation, otherwise it could risk causing the economy to suffer too much and a rise in unemployment.
To track economic growth in the US, the two important data releases are the GDP growth estimates and forecasts, as well as the non-farm payrolls, a key indicator for the employment market in the US. If the economy tips back into recession or there’s sustained weakness in the rate of growth of employment, then the Fed will have to act and provide support to the economy once again, which might mark the start of another bullish phase for the cryptocurrency market.
Summary
Hopefully this article has given you a brief introduction to the macro factors affecting financial markets and there are a lot of other important factors we haven’t touched on here.
Nobody can predict how the macroeconomic environment will play out in the future and you’ll find many differing opinions. The macro picture may or may not continue to heavily influence the cryptocurrency market, especially with major upcoming events like the Merge and Bitcoin’s next halving that may propel another bullish phase for the crypto market.
From now on, there’ll be two key macro drivers to look out for: an inevitable reversal in the Fed’s hawkish stance, which could mark the end of a bear market and start of a new bullish phase for cryptocurrencies.
Second, if the correlation between crypto and equities breaks down (also known as the decoupling) then it could signal that crypto will move more independently in the near future and mark the start of another bullish cycle. To track these trends, you can use the capital market insights on platforms like CoinMetrics and IntoTheBlock to see the correlation and historical trends of Bitcoin and Ethereum against different traditional asset classes (indices, equities, ETFs and commodities).
Until then, crypto traders will want to keep a close on macro developments, especially the evolution of interest rates in the US, the monthly data releases for the CPI as well as economic growth and employment trends in the US, which also affects monetary policy.