Fed and interest: understand one of the reasons behind the cryptocurrency correction

With a 4.97% drop in the last seven days, the price of Bitcoin (BTC) has returned to below $44,000. While it is a small correction by market standards, the move raises concerns as the cryptocurrency has again failed to break above $45K. Apparently, part of this drop has to do with a change in the attitude of the Federal Reserve (Fed), the central bank of the United States. According to the autarchy, the country’s interest rate should undergo more intense increases throughout 2022, with the objective of containing inflation. However, this interest rate increase will also be accompanied by a reduction in liquidity generated by the Fed. That is, the bank intends to sell a good part of its assets in the market. And that can have a strong impact on the price of risky assets – including BTC.

Inflation

While US inflation has approached 8% in the last 12 months, the prime rate is just 0.25%. For central banks, the interest rate is the main tool to control the rise in prices. That is, when inflation is high, the government raises the interest rate. This increase reduces economic activity, which in turn alleviates the upward pressure of inflation. However, the current rate of interest rate hikes by the Fed is still very timid. The last increase made in March was 25 basis points, taking the rate from 0% to 0.25%. But US inflation is very high, close to 8% – the highest rate in 40 years. This means that the US currently has a negative real interest rate. Thus, the Fed would have to increase the pace of interest rate hikes. And that is precisely what the central bank indicated, according to Lael Brainard, the institution’s governor.

“The Federal Open Market Committee (FOMC) will continue to tighten monetary policy methodically through a series of interest rate hikes and starting to reduce the balance sheet at a rapid pace as soon as our May meeting.” , said Brakard.

In this regard, the Fed not only plans to raise interest rates at a more intense pace, but will also withdraw more liquidity from the market. In other words, it will sell assets it holds on its balance sheet.

Biggest buyer on the market

The Fed’s balance sheet is made up of assets that the central bank itself buys from the financial market, mainly US government bonds. In return, the money used in purchases goes to the market, supporting the liquidity of bonds and stock exchanges. According to the Fed’s website, the institution’s balance sheet has more than doubled since March 2020. The graph shows that the Fed went from $4.2 trillion in March 2020 to $8.9 trillion in March 2022. Nearly $5 trillion was added in just two years.

With current data, the Fed has become the largest asset buyer in the US market. In practice, it is the central bank that guarantees the liquidity of the markets and their health. But now, the buyer has announced that it intends to start selling assets off its balance sheet.

The Fed’s Dilemma

While seeking to fight inflation, the Fed also wants to avoid a collapse in markets. After all, selling assets means increasing the supply of government bonds and mortgages on the market. In a tweet made on Wednesday (6), economist Fernando Ulrich commented on the Fed’s decision. Ulrich pointed out that the reduction in the Fed’s balance sheet could reach up to US$ 100 billion per month. That is, almost half a trillion reais being sold on the market every 30 days.

However, selling assets takes liquidity out of the market, which can greatly affect risky assets. On the one hand, a higher interest rate drives investors to seek government bonds, which are considered safer. At the same time, withdrawing liquidity makes less money available to investors. As a result, they will need to better choose where to allocate their resources. If demand for bonds increases, that means money outflows from markets considered riskier. In this sense, stocks and cryptocurrencies are the investments that tend to suffer the most, as they are seen as high risk by the market. Tech sector assets such as Apple, Tesla and Netflix, as well as BTC, are the most affected. Indeed, Wall Street reacted poorly to the Fed’s announcement on Wednesday, with the Dow Jones falling 200 points, or 0.6%. The S&P 500 index dropped 1%, while the Nasdaq 100 – which encompasses tech stocks – dropped 2.1%. Therefore, the Fed’s change in stance explains part of the correction movement in various global markets and also in cryptocurrencies. How intense this correction will be will depend on the central bank’s stance at the next meetings, where the interest rate must be revised again. Also read: Lawyer approved to preside over CVM promises “more attention” to cryptocurrencies Read also: Deputy submits Bill that limits values ​​for pledge of cryptocurrencies in Brazil since November 2021, says analyst