Crypto markets had a tremendous year in 2021, with Bitcoin and Ethereum leading the charge to new all-time highs. However, 2022 has been a different story, with crypto prices falling sharply this summer. While there are a number of factors that have contributed to the crypto market downturn, much of the blame can be placed on the policies of Central Banks and governments. In today’s article, I will be going into more detail about what has caused all this and why Crypto is the future.
In response to the market shock caused by COVID in 2020, Central Banks around the world cut interest rates and printed money at an unprecedented rate. This easy money policy helped to kick off a multi-year bull run in both equities and crypto, as investors poured into assets that were seen as safe havens from inflation. However, by 2021 it became clear that inflation was starting to spiral out of control, and that Central Banks would soon have to begin unwinding the same policies that had propelled markets higher in the first place.
So what happened?
It’s been a tough year for investors. In June of 2022, US equities took a hit, shedding roughly 20% of their value, or $10 trillion. This selloff, while not yet approaching the severity of other historically noteworthy downturns, is certainly in the conversation.
Crypto markets have seen even sharper declines, with nearly 60% wiped off the total market capitalization, or $1.7 trillion. For comparison, this is about on par with the 87% decline seen after the peak of the 2017 bull run.
BTC, ETH, and the NASDAQ all peaked in November, with the S&P 500 following suit at the end of December. So what changed during the last two months of the year? To understand this market downturn, it’s helpful to start at the beginning of a historic bull run that both stocks and crypto experienced in 2020.
The Federal Reserve response
The Federal Reserve, or the Fed, is the Central Bank of the United States and is thus responsible for maintaining the country’s financial stability. In times of extreme economic turmoil, the Fed steps in to support the economy. It does this mainly by controlling the supply of the US dollar which is the world’s reserve currency, keep that in mind. To increase the money supply, the Fed can engage in activities such as quantitative easing, which is when the central bank buys assets from financial institutions. This introduces new money into the economy and can help to stimulate economic growth. Another way that the Fed supports the economy is by setting interest rates. When rates are low, it becomes cheaper for banks to borrow money from the Fed. This also helps to increase the money supply and can boost economic activity. After COVID hit, the Fed lowered rates to near-zero in order to support businesses and households.
By digitally printing new money and using it to buy treasury bills and other securities from financial institutions, the Fed injected trillions of dollars into the economy. This increase in the money supply had a number of effects on the economy. First, it helped to encourage lending by financial institutions. With such a large amount of cash available, these institutions were forced to compete with one another to offer loans at lower and lower interest rates. This cheap credit, in turn, encouraged borrowing by businesses and consumers and helped to support the economy. Of course, there were also some downsides to quantitative easing, including inflationary pressures and concerns about moral hazard.
“Don’t fight the Fed” is an old investor mantra that implies that, given the Fed’s outsized influence, one should invest in lockstep with whatever direction the Fed is moving in financial markets. This mantra rang true after COVID struck in 2020.
When new money is being printed at record levels, and interest rates are near zero, all of this money and credit needs a place to go. On top of that, when rates are low, conservative instruments like bonds are less profitable, pushing money into higher-yield assets. In the aftermath of COVID, these forces caused massive inflows into stocks, crypto, and even NFTs, helping to push asset prices to new heights.
From their COVID panic-induced bottoms, the S&P 500, NASDAQ, BTC, and ETH would soar 107%, 133%, 1,600%, and 4,200% respectively. While it’s impossible to predict the future direction of the markets, it’s clear that the Fed will continue to play a major role in shaping them. As such, investors would be wise to heed the old mantra and “don’t fight the Fed.”
When Paul Tudor Jones compared Bitcoin to “the fastest horse,” he was talking about its potential as an inflation hedge. And, for a while, it looked like he might be right. From May 2020 to the present day, Bitcoin is up over 200%. That’s well ahead of inflation. But, if you’d bought Bitcoin after inflation started to rear its head, you wouldn’t be doing so well. Even with the recent correction, Bitcoin and ETH are each up 500% and 1,000% from their pandemic lows. But, longer tail assets have not fared as well. It’s hard to deny that crypto has been highly correlated with stocks – particularly tech stocks. Tech stocks are considered risk assets. And, given the correlation, it’s fair to say that most individuals are still treating crypto similarly. Risk assets carry high upside, but they also come with high downside risks. So, while Bitcoin may have started out as an inflation hedge, it has become something else entirely.