Crypto Markets Throw Tantrum as Fed Prepares To Target Inflation

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Inflation has become an urgent topic of discussion ever since the U.S. Federal Reserve released minutes of its December meeting, indicating that it’s willing to take a harder line on inflation, which hit a 39-year high in December.

Crypto markets were hit hard over the last two weeks, with Bitcoin briefly trading below $40,000 for the first time since September 2021. Markets have since recouped some losses after the US Consumer Price Index (CPI) data this week came out just above expectations.

But why is inflation suddenly in the spotlight? And why have crypto investors become ardent Fed-watchers? Aren’t we building a new financial system that’s supposed to be independent from TradFi? 

To answer those questions, we’ll need to look back at the last two decades.

Extraordinary Measures

At the depths of the financial crisis in 2008, there was clearly a need for unprecedented action to prevent a total collapse of the financial system. Global central banks worked in tandem to flood the system with liquidity and bailed out troubled banks using public funds.

The results were immediate. Global stock markets rallied strongly, and we went back to business as usual. Fears of triggering another recession by withdrawing stimulus measures too soon resulted in interest rates remaining artificially low for far longer than necessary.

Politicians around the world quickly realized that turning on the money printer was an easy solution to crises. Rising stock markets coupled with low inflation meant they could spend their way out of problems while maintaining public support. The wealthy saw their fortunes multiply beyond imagination as liquidity flowed into financial assets like stocks and real estate, while the average Joe continued to plod along with the prices of everyday goods remaining relatively stable.

Whatever It Takes

The European debt crisis a decade ago prompted ECB chairman Mario Draghi’s famous pledge to “do whatever it takes” to save the euro, and the practice continues to this day, as we’ve seen with trillions of dollars in COVID stimulus measures.

Now, an entire generation of investors has become accustomed to an era of cheap money, facilitated by the Fed and other central banks around the world over the last fifteen years.

Satoshi Nakamoto developed Bitcoin as a response to the global financial crash and the Great Recession of 2008-09. One of the driving factors was a fear of inflation due to a rapidly increasing money supply. 

Well, here we are 16 years later, and the US money supply has almost tripled at an unprecedented pace.

“Inflation is just like alcoholism. In both cases…the good effects come first” – Milton Friedman 

Why Inflation Matters

While moderate inflation is healthy for a growing economy, economists fear excessive price hikes over a prolonged period can lead to hyperinflation and a complete loss of confidence in the national currency. People expect their money to be worth less in the future, and sell their currency for other assets as soon as they receive it, exacerbating a vicious cycle of devaluation.

Hyperinflation is truly a nightmare scenario for any nation, as people’s hard-earned savings become virtually worthless overnight. We’re seeing it unfold right now in Venezuela, where annual inflation was 686% in 2021

Consider that figure for a moment. Can you imagine your net worth being slashed by 85% in a single year just because you held your savings in your national currency, as most people do? 

History is replete with examples of failed currencies, and so central banks tend to take action long before the situation gets out of hand.

Tough Choices

This brings us back to the Fed’s recent pivot.

Since the ‘COVID Crash’ of March 2020, the Fed has kicked the money printer into overdrive, injecting $120B of liquidity into the markets every month through bond purchases. Benchmark interest rates were once again dropped to near-zero, reversing the hikes of 2016-2019.

In such an environment, speculators are rewarded at the expense of savers. Ordinary people want to save money for college tuition or a new house, but with bank deposits yielding next to nothing, they are forced to risk capital in the stock market.

There’s no doubt 2021 was a great year for risk assets, as everything from coffee to crypto rallied higher. But it’s the rapid rise in the prices of essential goods that’s spurring the Fed to take action.

On November 3, it announced that monthly bond purchases would be scaled back by $15B a month, with the program expected to be wound down by Summer 2022. At the time, no interest rate hikes were pencilled in for 2022.

As the world’s reserve currency, the majority of risk assets are priced in US dollars. A weaker dollar is generally considered positive for risk and credit markets. The mechanics of how this works through the Eurodollar market are beyond the scope of this article, but you can read more here.

The greenback rallied sharply in the wake of the announcement and proceeded to hit levels last seen in July 2020 over the next three weeks.

Bitcoin topped at $69K on November 10 and dropped 30% over the following month as total crypto market capitalization dropped to $2.2T from a high of nearly $3T.

We’ve seen a lot of institutional adoption of crypto in 2021, and while that is undoubtedly positive for the space, it could also explain crypto markets’ increased sensitivity to monetary and fiscal policy. Old habits die hard on Wall Street.

One must understand that professional investors are not degens. Money managers are expected to operate within strict risk management parameters or risk losing their cushy Wall Street gigs. With the consensus view expecting tighter monetary conditions going forward, fund managers will look to pare risk. 

If we look at the risk spectrum of asset classes, crypto can be considered one of the riskiest. So, it’s a natural place for asset managers to start cutting positions to protect their outsized gains of 2021. Most institutions are trend-followers and will not hesitate to exit their positions if macro conditions call for it.

How many banks announced crypto trading desks in 2017 and 2018 only to abandon their plans when the market imploded?

Targeting Inflation

On Dec. 15, the Fed announced that it would accelerate the reductions in monthly bond purchases and end the program by March 2022. While markets took the news in stride, the minutes released last week showed that the committee now expects as many as three rate hikes in 2022.

Investors generally don’t like surprises, and this time was no different. Equity markets traded lower and we saw another wave of selling in crypto, with Bitcoin and Ether briefly trading below $40,000 and $3,000 respectively.

What To Expect

Bond markets currently predict a 78% chance of a 0.25% hike in March.

Investment bank Goldman Sachs says the Fed will raise rates four times in 2022.

While the majority of investors seem to be taking the Fed’s projections as a done deal, there are some factors that may yet influence the actual path taken by the world’s largest central bank.

For one, 2021 may have been an outlier. A combination of supply shocks caused by the COVID pandemic and direct monetary stimulus boosting consumer demand may have resulted in an inflation spike. If this is the case, we can expect inflation to abate naturally as conditions return to normal.

Secondly, this is an election year in the US. While Democrats will want to present themselves as tough on inflation, they would also want to keep the markets stable. An overcorrection leading to a stock market crash would hurt the incumbents. If the pandemic were to worsen or the economy runs into headwinds, we can’t rule out the possibility of another stimulus package.

Negative Funding

In the short term, the bounce is likely to continue, as funding rates have turned negative, indicating that traders are being paid to open long positions.

Previous periods of sustained negative funding rates have tended to precede positive price action.

If we think of the US Dollar as a crypto token, the Fed can be viewed as the developers controlling its supply.

For the last two decades, they’ve been hitting the ‘infinite mint’ button.

Now, with inflation in the spotlight, will the devs do something?

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