The cryptocurrency market is just one of the small cogs of a larger machine, which is the global financial markets. Larger markets such as real estate, commodities, US stocks, and many more follow different sets of regulations and economic principles that either directly or indirectly affect how they move. Though cryptocurrency is still (for the larger part) an unregulated financial frontier, it is still affected by these economic principles and regulations.
FOMC And Interest Rates
A large majority of cryptocurrency traders have heard of FOMC and pray for rate cuts but don’t exactly fully understand what they mean. FOMC, or the Federal Open Market Committee, is a 12-person committee that is responsible for setting monetary policies, usually through influencing interest rates.
To not overcomplicate the already complex model of interest rates, let’s burn this into your mind: increasing rates means the FED is tightening to combat inflation, while cutting rates looks to ease the tension in the market to allow for economic growth. Both are necessary to have a healthy and stable economy.
What Happens If We Just Keep On Raising Rates?
In the wild and hypothetical scenario where the FED decides to fight inflation and never bother to stimulate the economy, progress and innovation start to plateau. With loans being too expensive to incur, many businesses and investors are less incentivized to be risk-on and grow due to the harsh economic environment. A slow bleed towards a quiet death in the economy would happen.
What Happens If We Just Keep On Cutting Rates?
If the FED decided to party like it never has before, for a brief moment, the markets would rejoice and investors would get wealthy. As you should know, the market does not like if too many people are getting rich, making assets “easy money.” Once the market realizes this, a blow-off top would likely happen as either assets or currencies would blow up. While the up-only party is euphoric, the elevator down would take us back to the Great Depression.
Now you understand how crucial it is for the FED to maintain the balance between increasing and cutting rates, how does this affect the cryptocurrency markets? The majority of investors are risk-averse or not inclined to take unnecessary risks. Crypto is usually the very first asset to get snipped out when things are uncertain because the majority of investors have it as a wildcard investment. Unless cryptocurrency becomes a safe-haven asset, it will always be subject to volatility due to its speculative nature.
Quantitative Tightening And Easing
Let’s talk about money printing. Quantitative Tightening and Quantitative Easing are two opposite monetary policies that central banks use to manage both money supply and interest rates. It’s a period of rate cuts or hikes with the moderation of money printing to stimulate a desired economic reaction.
What Causes A QT? What Happens?
For central banks to curve the fear of market overheating and inflation, they switch the money printer off and start reducing money supply. With the money supply being stagnant, markets no longer get stimulated for it to go up, causing a decline in volume. With everyone going back to the dollar, the yields on treasury bonds go up to be used to combat inflation and pay government debt.
To keep things short, low liquidity causes low volume that then causes price to plummet.
What Causes A QE? What Happens?
When central banks look at inflation data and come to a conclusion that inflation has been sufficiently dealt with to start easing monetary policies, they look to stimulate the economy by encouraging people to be risk-on. During quantitative easing, money is being printed for the government to buy assets. This reduces the yield on bonds and encourages investors to get out of them and find better returns on their investments. Additionally, with interest rates being low during a QE, investors are incentivized to take low-interest loans to purchase high-yield assets to generate income.
With the new influx of money entering the market, charts that follow the time’s narrative would rally to new heights.
How Does This Affect Crypto?
In comparison to other asset baskets, crypto is only a measly $3 trillion dollar market cap compared to US Stocks ($51T) and Real Estate ($379T). Lower market cap means higher volatility, allowing crypto to react more violently to shifts in monetary policies. When quantitative tightening starts, risk-averse investors would choose it as the very first asset that they’re willing to part ways with. However, with quantitative easing, crypto’s miniscule market cap will positively react violently due to investors being incentivized to be risk-on.
M1 And M2 Money Supply
To keep M1 and M2 money supply as easily understandable as possible, it is the amount of liquid funds (cash and liquid assets) readily available in banks, while M2 includes civilian savings accounts as well. This also includes money the central bank can magically increase by adding a few zeroes into the system via credit. The M1 and M2 money supply is usually a tell-tale sign of the market’s readiness to respond to current economic sentiment.
Cryptocurrency requires liquidity in order to keep the ball rolling. Just like any market, volume is the most important information about its state, which requires tons of liquidity being moved through buys and sells. The M2 money supply identifies how much readily-available liquidity there is to grab, making it a neat indicator for investors to know whether or not the harvest is ready. However, the M2 money supply is not a guaranteed indicator of future price, as liquidity will have to flow in crypto based on investor’s preference.
If M2 money supply is favorable, there’s no point in using it as hopium for a coin with dead volume. It’s merely information on how much readily-available money there is.
CPI And Inflation
At the end of the day, market participants are human after all. Besides financial institutions, retail participants also have real weight into the economy. CPI, Inflation, and even Unemployment are frequent market terms you may hear from time-to-time that are usually accompanied by a percentage or number in a report.
Here’s a short story on how an average man lives with poor CPI and Inflation data:
A man who is earning $45,000 a year in 2019 has an average expense of $3,100 a month, leaving him some spare money of $700 every month. He then uses that $700 for clothes, coffee, eating out, and other luxuries. If he’s smart, he may also use it for investing.
However, in 5 years, he has doubled his income and retained his lifestyle. He never moved out and still maintains his usual spending habits with an income of $90,000. However, he suddenly found himself not saving anything despite not changing a thing in his lifestyle. While his income has doubled, his purchasing power became worse as inflation increased the prices of goods and devalued his money.
Now, ask yourself this question: If you were the man above, would you risk investing in a speculative asset such as crypto?
These are issues faced by the common man, making the barrier to enter cryptocurrency an intimidating one. However, aren’t financial institutions contributing the most value to the markets? Why should they care about inflation and CPI when their lifestyles aren’t affected by it?
Here’s another perspective:
A millionaire entrepreneur who founded a casual dining restaurant chain has the majority of his wealth in his own stock. His net worth reached all-time high as both his company’s stock and profits skyrocketed due to months of having fully-booked dinner services. However, over the years, he had to steadily increase the prices of his menu items due to the rising cost of raw goods such as flour, oil, and meat.
Fast forward to 5 years later, people can no longer afford to unnecessarily spend spare money to eat outside and have decided to cook at home. His profits hit a new low, making his P/E ratio unattractive. This pushes investors to pull out of his failing business and incur losses in the stock.
Now ask yourself this question: Is the millionaire entrepreneur still as rich as he was before?
The same goes for cryptocurrency. If people are unable to afford to spend spare money on luxuries and investments, why would they buy crypto?
Final Words
These are just one of the few economic concepts that affect cryptocurrency, more additions will be added into the future. These macroeconomic events shape global finance, not just cryptocurrency. FOMC rate decisions that push and pull quantitative policies, liquidity indicators like M2, and inflation data are all considerable options investors have to assess before dealing with risky assets such as crypto.
Join the Discord server here: https://discord.gg/ad8tH4B5ZU
