In-Depth Analysis: How does the macro economy affect the cryptocurrency market?

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Cryptocurrencies themselves as an established asset class and the entry of institutional investors mean that the prices of large-cap stocks such as bitcoin and ethereum are increasingly intertwined with the broader financial markets.

The rising correlation with the S&P 500 Index (which tracks the stock performance of 500 large companies listed on US exchanges) was not observed until 2020, as shown in the chart below. The price growth of stocks and cryptocurrencies is more highly correlated than ever, reaching an all-time high in May 2022.

Whether this correlation will last remains to be seen, but the correlation between cryptocurrencies and the stock market means that the fundamentals and events that affect the stock market may also affect the crypto market.

As the market grows to a sizeable size, the macro picture becomes more and more relevant to cryptocurrencies. While still small compared to other financial markets, it is becoming harder to ignore and become a fad. But what exactly do we mean by macro?

Macro refers to macroeconomic trends at a national and global level, such as economic growth, inflation, interest rates, employment, and geopolitics. Macro traders use stocks, bonds, currencies and commodities to express their views.

Importantly, the main drivers of these markets are fundamentals. One of the best examples is interest rate differentials, where investors buy a currency when interest rates rise and sell a currency when rates fall or stabilize at a very low level.

A recent example is the appreciation of the dollar against the yen, which has risen against the yen due to rising U.S. interest rates and Japan's commitment to easy monetary policy.

Just like commodity traders, the equities and forex markets have to keep their finger on the pulse of macro events, which is becoming important for crypto traders as well. As the main drivers of financial markets, key macro indicators relate to monetary policy, which refers to trends in interest rates, inflation, economic growth, and geopolitical events.

Let’s start by taking a deep dive into monetary policy and how this macro driver has impacted the crypto market recently.

Monetary Policy: ELI5

Monetary policy refers to the use of interest rates, changes in the money supply, and quantitative easing (QE) or quantitative tightening (QT) to affect the economy. The federal funds rate is the benchmark for U.S. interest rates and determines the rates on loans to businesses and consumers, as well as the return on capital for savers.

The Federal Reserve decides interest rates eight times a year, and the Federal Open Market Committee (FOMC) weighs economic data to make those decisions. It's good to know when these meetings are so you can prepare ahead of time, and you can use this calendar to find all upcoming FOMC meetings.

Since the results of these meetings and accompanying press statements typically have the greatest impact on financial markets of all macro events, there is a lot of volatility during these announcements.

As the chart below shows, since 2020, BTC’s intraday volatility has been nearly 40% higher on monetary policy statement days, while ETH’s intraday volatility has been nearly 12% higher than all other days.

To interpret the statement and minutes (released about a month after the rate announcement and statement, but with lesser impact), it is important to understand two terms:

• Hawkish: This is described as hawkish when the economy is doing well and policymakers want to raise interest rates to curb inflation.
• Dovish: This is described as dovish when the economy is struggling and policymakers tend to lower interest rates to boost the economy.

When Fed officials speak, traders will be watching how hawkish or dovish Fed officials will determine future interest rates and economic trends, and how this will affect financial markets in the near term.

Why is monetary policy an important macro theme?

Monetary policy is also one of the most important determinants of the strength of a country's currency, as interest rates also affect capital flows and currency strength. In the years following the 2008 global financial crisis, interest rates remained very close to zero.

As the economy collapsed, the U.S. central bank eased conditions (the Federal Reserve, or Fed for short) to stimulate demand and growth, and lower interest rates provided lower borrowing costs for individuals and businesses to consume and invest.

In short, interest rates are used as a lever to affect demand, which in turn affects inflation and economic growth. As we can see from the chart below, interest rate cuts during recessions are intended to boost demand when things get worse. However, when the economy is growing, there is room to raise interest rates to ensure that the economy does not overheat, demand outstrip supply and inflation runs rampant.

The way monetary policy affects the economy is shown in the diagram below and is known as the monetary policy transmission mechanism.

Most importantly, for crypto investors, changes in official interest rates affect the market value of securities, such as shares.

This is because expected future returns are discounted by a larger factor, so the present value of any given future income stream falls. Also, since investors can earn more dollars from interest-bearing assets such as U.S. Treasuries, the relative attractiveness of these safe-haven assets increases and reduces interest in risky assets such as stocks and cryptocurrencies.

On the other hand, lower interest rates stimulate asset prices, making it less attractive to save dollars or buy bonds because the returns are not as high as cryptocurrencies or stocks.

Changes in official interest rates increase or decrease the value of a country's currency. When interest rates fall, this boosts exports because the currency will weaken (by reducing capital flows and dollar outflows), but it also causes asset prices to rise, such as stocks, real estate, commodities like gold, and cryptocurrencies like Bitcoin.

In addition to the value of stocks and the dollar itself, interest rates also affect the price of bonds. Rising interest rates lower bond prices, and vice versa, lower interest rates. Bonds, which are essentially loans to governments with guaranteed returns, are considered one of the safest assets.

For example, 10-year U.S. Treasury yields are widely observed indicators in global markets because they reflect the economic outlook and drive global financial conditions. High interest rates are associated with tighter financial conditions, while low or even negative yields lead to easier global financial conditions – leading to a “yield seeking” effect that pushes up asset prices and may also encourage greater risk-taking – — This is generally seen as a positive sentiment towards cryptocurrencies as an asset class.

A Brief History of Cryptographic Macro Interactions

As we showed above, throughout the existence of Bitcoin and Ethereum, the base rate in the United States has been very close to zero. The lower bound is zero because interest rates below zero are not feasible. Because of cash, central banks cannot implement negative deposit rates because people just take their money out of their bank accounts and keep it in cash.

But negative interest rates have been seen as a potential tool for future monetary policy, made possible by banning cash and introducing central bank digital currencies. These are the developments that could affect the cryptocurrency in the future and are one of the main bullish arguments.

To provide a more accommodative environment after the 2008 global financial crisis, the Federal Reserve and other major central banks introduced quantitative easing rather than cutting interest rates below zero, which inflated the size of these central banks' balance sheets relative to the size of their economies .

The cryptocurrency market exploded during 2016 and 2017, and while interest rates are rising, they are still very low by historical standards. But as U.S. interest rates rose above 1 percent and the crypto market entered a bear market after overextended valuations, investors were exiting in favor of safer assets.

The Fed tried to reverse QE in 2018, but failed to do so without spooking markets (including cryptocurrencies), and is only now talking about QT again, QT refers to the Fed's easing of support for financial markets, i.e. dumping of Fed assets Lots of mortgage-backed securities and U.S. Treasuries on the balance sheet.

Still, cryptocurrencies are still in development at this point, and the chart below shows how Bitcoin's market capitalization in 2020 will grow with the dollar money supply as cryptocurrencies gain more legitimacy and maturity as an asset class. increased sharply and rapidly.

In response to the Covid-19 pandemic and the free fall of financial markets in March 2020, the Federal Reserve made emergency rate cuts to bring rates back to the zero lower bound, while significantly increasing the size of the Fed's balance sheet.

The 10-year Treasury yield turned negative during the Covid-19 pandemic and following the policy response of cutting interest rates to near zero. This has put downward pressure on yields as the Federal Reserve purchased U.S. Treasuries through its quantitative easing program to support financial conditions and lower long-term interest rates to stimulate the economy.

Similar to the aforementioned case where the interest rate differential between the U.S. and Japan has been driving USD/JPY price action, the divergence between the money supply growth of cryptocurrencies like Bitcoin and Ethereum is increasingly seen as The main driver of price action. In the wake of the Covid-19 pandemic, the Fed has massively stimulated and promised unlimited monetary support, a fundamental theme popularized by traditional macro investors such as Paul Tudor Jones.

But as money supply growth has gradually slowed, and the Federal Reserve has become more committed to reversing the quantitative easing policies that have long supported financial markets, we have recently seen the annual growth rate of Bitcoin's market capitalization and the entire cryptocurrency market take a hit.

But what is the potential path ahead for U.S. interest rates? What is the impact on cryptocurrencies? To answer this question, we must examine trends in economic growth and inflation.

The Role of Inflation and Economic Growth

Most central banks, including the Federal Reserve, are tasked with maintaining a generally stable but low price level across the economy. A low and stable inflation rate is desirable because investors and consumers can plan for the future, know that prices will not change rapidly, and have confidence in the future, which will support economic growth.

As such, inflation data can help traders gauge how interest rates may evolve in the future, and the Fed's most important inflation indicator is the Consumer Price Index (or CPI for short). CPI data is released monthly (between the 10th and 15th) and typically has a significant impact on financial markets, including stocks, bonds and, most recently, cryptocurrencies.

If inflation is above target or higher than expected, it suggests the central bank may do more to keep the economy from overheating by raising interest rates. As inflation has risen rapidly over the past year, the CPI has grown in influence on the cryptocurrency market, as the data plays an important role in shaping monetary policy.

However, as mentioned earlier, there is a difference between money supply growth and inflation in fiat currencies like the U.S. dollar and cryptocurrencies like Bitcoin and Ethereum. With inflation at a 40-year high, the Federal Reserve was forced to raise interest rates, negatively impacting the macro picture for cryptocurrencies. As interest rates rise, inflation should eventually fall, reducing the need for an inflation hedge.

However, once inflation has clearly peaked, the Fed will become less aggressive in raising rates and we should see a softening of their stance as growth takes center stage. As interest rates rise, it not only keeps inflation in check but also drags down economic growth. Borrowing for investment and consumption has become more expensive, exports have become less competitive, and debt servicing has become more expensive.

In addition to targeting low and stable inflation, another role of the Fed is to ensure full employment. On the one hand, a central bank like the Fed needs to balance inflation and manage expectations so that prices don't get out of hand. But on the other hand, they can't continue to raise interest rates to curb inflation, otherwise it may cause too much damage to the economy and increase unemployment.

To track economic growth in the U.S., two important data releases are GDP growth estimates and forecasts, and non-farm payrolls, a key indicator of the U.S. job market. If the economy slips back into recession or job growth remains weak, the Fed will have to act again and provide support to the economy, which could mark the start of another bullish phase for the cryptocurrency market.

Summarize

Hopefully this article has given you a brief introduction to the macro factors that affect financial markets, there are many other important factors that we have not covered here.

No one can predict how the macroeconomic environment will develop in the future, and you will find many different opinions. The macro situation may or may not continue to have a significant impact on the cryptocurrency market, especially with upcoming major events such as mergers and Bitcoin’s next halving, which may propel the cryptocurrency market into another bullish phase.

From now on, there will be two key macro drivers to watch: an inevitable reversal in the Fed’s hawkish stance, which could signal the end of the bear market and the beginning of a new bullish phase for cryptocurrencies.

Second, if the correlation between cryptocurrencies and stocks breaks (also known as a decoupling), then it could indicate that cryptocurrencies will move more independently in the near future and signal the start of another bullish cycle.

Until then, cryptocurrency traders will want to keep a close eye on macro developments, particularly the evolution of U.S. interest rates, monthly CPI data releases, and U.S. economic growth and employment trends, which can also affect monetary policy.