Why interest rate rises are a problem for cryptocurrency investing

Investment appeal of crypto and NFTs

• The old chestnut: Supply and demand

Cryptocurrency is often described as being ‘a bit like gold’ which some people, wrongly, argue has no intrinsic value. In fact, most economists will argue that gold does have intrinsic value, but that’s a debate for another day. The fact remains that in the case of both cryptocurrency and gold, the underlying price depends to a large extent on the law of supply and demand – rather than the core ‘use’ of the product. This is quite different from other markets, such as oil.

The facts are that there are only 21 million bitcoins. About 19 million are already in circulation, and the rate at which new coins are created is halved approximately every four years, which means that they could feasibly continue to be mined until around 2140. But, just because something is ‘rare’, it doesn’t automatically mean it has value.

• Quantitative easing oiled the wheels

Now, introduce into the mix the central banks’ quantitative easing – increasing the money supply and near-zero interest rates – that began in late 2008 in response to the GFC. The new crypto assets were an obvious – albeit risky – investment target for the newly abundant liquidity. They attracted short-term traders, longer-term investors looking for a way to store value, create wealth and hedge against inflation, and financial institutions who devised Bitcoin investment vehicles such as ETFs. Major investment banks, which were initially sceptical of Bitcoin, began to allow their own trading floors to invest in these products.

When money is plentiful, cryptocurrency investment can look attractive even when the rewards may be years away. This is the same mindset that allows start-up tech companies to find investors when they are haemorrhaging cash and there’s no guarantee they will ever make a profit.

• Rise of NFTs

Like cryptocurrency, non-fungible tokens (NFTs) have their basis in blockchain.  Blockchain’s properties of immutability, security, and transparency– or provenance – make it an optimal technology.  (The debate lingers on the value of cryptocurrencies that essentially do the same as currency, but mask their source of funds.) Each NFT is a unique digital identification representing ownership of an asset, such as an artwork, intellectual property, or even real estate. Investment in NFTs also benefited from quantitative easing and people looking for new asset classes on which to spend their readily available cash. Artwork NFTs have changed hands for millions of dollars – and this approach is tipped to continue influencing the world of art.

• Traditional investments’ declining returns

Why leave your cash in a savings account earning 0.1% p.a., or invested in a slow-moving blue-chip stock, when other people are making fortunes overnight on crypto? Well, that’s how the argument went, and it was tempting to have a bit of a punt even if you stopped well short of sinking your life savings into it.   Experienced investors and advisors generally exercise caution – aware of the inherent risk/return trade offs – when asset classes are showing exuberant returns. (And in my opinion, shorting against this sort of asset class is fraught with danger. To quote Warren Buffett, ‘markets can stay irrational longer than you can stay solvent’.) However, the potential for returns on crypto was, and will inevitably continue to be, a driver for investment activity.

Inflation and interest rate rises and the crypto crash

The party may be over for cryptocurrency in the short term. In November 2021 both Bitcoin and Ethereum traded at their all-time highs of US$68,789 and US$4,891, respectively. In June 2022, on the same day that the US Federal Reserve increased its interest rate by 0.75 percentage points, Bitcoin plunged to US$20,971, down 70% from its high. Ethereum also fell below US$1,000 in June. Meanwhile, NFT investors trying to sell their assets lost millions.

What caused the crash? There are some obvious culprits.

• Quantitative tightening

How times have changed. Australia has followed the rest of the world this year in tightening monetary policy. In May, the RBA governor said the bank’s contracting balance sheet – the result of not replacing maturing bonds – would contribute to tightening of financial conditions. Interest rates also began rising in May, and more rate increases are a certainty. This means there’s less cash to spend on non-mainstream assets like cryptocurrency and NFTs.

• Inflation-stimulated demand for income-producing assets

As prices for goods and services rise rapidly, investors are abandoning speculative future profits in favour of assets that will produce current income, such as bank deposits at higher interest rates, and shares in established companies producing in-demand items like food and energy.

• Crypto/stock market correlation

Cryptocurrency is not alone in its recent downward movement. Amazon, Apple and Meta, NASDAQ and even the S&P 500 all recorded serious mid-year dips in 2022, demonstrating that a more mature crypto sphere is starting to react to monetary policy changes in the same way as the broader investment market.

But there’s more to the story

Cryptocurrency, however, hasn’t completely lost its shine. Both Bitcoin and Ethereum have rallied slightly since June, the law of supply and demand is still operating, major companies hold crypto assets and facilitate crypto payments, and financial institutions have not withdrawn their cryptocurrency ETFs.

There are those who argue that the cryptocurrency industry is still in its infancy, evolving and continuing to come to terms with a greater focus on government regulation. All of these factors can have an impact on the market, beyond the temporary blips caused by changes in monetary policy.

On the flip side, the more crypto becomes regulated, the more it begs the question – what does it achieve that currency doesn’t? In an era of immediate international payments – backed by banks – what value does cryptocurrency hold?  Keep watching this space.

Disclaimer: This information is general in nature and should not be relied on as advice. It does not take into account the objectives, financial situation or needs of any particular person. You need to consider your financial situation and needs and seek professional advice before making any decisions based on this information.