The Fed could once again tank crypto

The bear-market of 2022 was caused also by the Fed, hurting the crypto sector. 

Although the bursting of the 2021 bubble would have started a bear-market anyway, the Fed drained a lot of capital from financial markets, exacerbating the problem. 

Moreover, the 2021 bubble had been created by the Fed, injecting more liquidity into the financial markets than it had ever injected before in its entire history. 

But this time things seem to have changed, for the better, although some risk is still there. 

Repos on the decline

One of the dynamics by which the Fed unintentionally drained liquidity from the financial markets are the so-called Overnight Reverse Repurchase Agreements (Reverse Repos). 

It can be seen from the graph that they began to grow significantly as early as April 2021, when the first phase of the last big bull run ended, for example, but QE was still underway. 

QE began to slow in early 2022, and was stopped altogether around March of that year. 

At that very time the second ascent of the Reverse Repo curve began, which went on until June of that year, which is when the collapse of the crypto markets momentarily stopped. 

After a small descent, the Reverse Repo curve rose again in early 2023, reaching a new peak in late April. It is most likely no coincidence that in May the US financial markets rose again. 

The fact is that this descent is still ongoing, so much so that the current level of Reverse Repo has fallen to figures not seen since June 2022. 

If the downward trend is confirmed, liquidity could increase in the short term in the U.S. financial markets, which could be good for crypto markets as well. 

But the descent could also stop at current levels, which are the lowest in twelve months. 

Fed: the problem of rates and the impact on the crypto market

The real issue is another. 

By now everyone assumes that at the end of July the Fed will raise interest rates on debt for one more time, with a minimum 25 basis point increase. 

The problem, however, is that the Fed could raise them again in the following months. 

Right now the markets are giving the July increase as extremely likely, but they do not believe in further increases. 

Instead, Fed Governor Jerome Powell has already stated several times that the the FOMC assigned to decide on rates believes two more hikes are appropriate. 

In other words, markets do not believe Powell’s words, and expect only more hikes. 

On the other hand, if in September, or in November, the FOMC were to actually decide to raise rates a second time, markets might take it badly. So there is a risk that in the fall the Fed will once again hurt financial markets, including crypto markets. 

Inflation

However, there is a reason why markets right now do not believe in a second rate hike in the fall. 

In fact, these rate hikes hurt the US economy, but they are necessary to try to reduce inflation. 

The fact is that inflation is falling, and in a big way. While it was at 9.1% a year ago, by May 2023 it was down to 4 %, or less than half. 

Thus, such high interest rates (the highest in decades) are actually helping inflation come down significantly, but the Fed may not be satisfied. 

Indeed, the US central bank fears two scenarios that have not yet been averted. 

The first concerns the pace at which inflation is falling. A year ago that pace was very strong, but for the past few months it has slowed. It is enough to say that in March inflation was at 5%. At this pace it will still probably take all of 2024 to bring it back to 2%. 

The second is the very slow decline in the so-called core inflation, which is inflation excluding food and energy. Even core inflation in March in the US had increased, and from December 2022 to May 2023 it only fell from 5.7% and 5.3%. 

The Fed uses this specific parameter, and not inflation in general, to decide its monetary policies. This is why it is likely to raise interest rates again in July despite the sharp decline in general inflation. 

According to Powell’s statements, the Fed does not expect core inflation to fall significantly in the coming months, so much so that the FOMC is already planning a second rate hike by year-end. 

Instead, markets seem to be betting on a sharp reduction in core inflation by year-end as well. 

Fed decisions and the consequence for crypto markets

In the event that the markets are wrong, and the Fed ends up raising rates again in the fall, these same markets would be forced to run for cover, pricing in a further increase that they have not priced in as yet. 

In contrast, in the event that core inflation were to fall significantly in the coming months, the situation could remain much the same as it is now, because markets are apparently already pricing that scenario in. 

As such, the Fed could still tank the crypto markets if it opts for even tighter monetary policy in the fall, despite the fact that as of now the markets believe it won’t.