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What Will Happen to Crypto If The Fed Begins Tapering?
2021-10-07, 06:50
Fed’s tapering will start as early as the end of this year, when the Fed will gradually reduce bond purchases.
The Fed is expected to start its interest rate hike cycle in 2022-2023.
Taper Tantrum is a major risk to asset markets today.
The risk sparked by the possibility of U.S. debt default at the end of October has also created uncertainty in terms of outlook for financial markets.
BTC has soared over the past seven days, breaking $50,000 and reaching its highest point since May.
[Keywords] Federal Reserve, Tapering, Monetary Policy, Quantitative Easing, Bitcoin
On September 23, 2021, the U.S. Federal Reserve released its sixth monetary policy statement of the year. It will keep the zero interest-rate policy that was implemented in March last year. It also said that if the economic recovery is in line with expectations, it will begin to taper bond purchases soon. At the same time, half of the Fed officials believe that we will see an interest rate hike in 2022. Almost all of the officials expect rates to start rising by the end of 2023. Only one official believes this won’t happen. The Fed chair, Jerome H. Powell had an even harsher stance at the press conference. He emphasized the shift in monetary policy arrangements, and insinuated the rate rise may be earlier than previously forecasted.
It’s the Federal Open Market Committee (FOMC) that discusses and publishes the Fed's interest rate decisions which are issued eight times a year. At the August and September meeting on interest rates, the Fed signaled they would taper bond purchases and let the market work off superfluous bonds. There will be two more announcements from the FED this year regarding interest rates. These announcements will be on November 3rd and December 16th. It is expected that the scale of tapering bond purchases will be discussed specifically.
In the first quarter of last year, when the global market witnessed the Covid-19, U.S. stock market crash and even saw consecutive trading curbs. The Fed decisively launched a rescue operation and announced the start of ultra-loose monetary policy. It also said that there will be unlimited purchases of U.S. Treasury securities and MBS(Mortgage-backed securities) to provide the necessary liquidity to the market. They believed that, this way, investor confidence would be gradually restored. Stocks also bottomed out and did not collapse completely. As the U.S. economy gradually recovers from the gloomy period that sparked from the Covid-19 pandemic, data indicators like employment and consumption have improved. The Fed will gradually tighten its monetary policy as the economy improves. The Fed’s tapering announcement has let the global capital markets(including crypto coin markets) who have been watching, to know that tapering is finally coming.
For more information on how the Federal Reserve implements loose monetary policy and how it subsequently affects crypto asset prices, please read on:
What Is the Fed Tapering?
What is the Fed Tapering? Let’s start with the word “Taper” which originally refers to “wick or cone”. If used as a verb, it means "gradually reduce or shrink". In the financial field, it indicates the gradual reduction in the size of the assets purchased by the central bank to remove liquidity, and it is the reverse policy of quantitative easing (QE).
In the expansionary monetary policy, the central bank mainly utilizes conventional approaches such as lowering the reserve ratio or reducing the rediscount rate, and Open Market Operations to increase the currency supply. When market interest rates are near to zero and conventional policies are no longer effective, the economy still needs to be stimulated. The central bank will usually implement quantitative easing, to purchase large amounts of medium and long-term bonds such as Treasuries in order to anchor low or even zero interest rates for a long period of time. In ordinary open market operations, the central bank generally only purchases short-term bonds. This is to regulate the money supply and fine-tune interest rates. Quantitative easing, on the other hand, mainly uses the open market account (SOMA) to buy medium- and long-term bonds. Therefore, quantitative easing is also known as "pump-priming" or a "money-printing" policy.
QE has a profound impact on the economy. The Fed will consider it carefully before exiting from QE and give the market sufficient time to react. According to historical actions, the Fed will follow these steps: release tapering signals; formally taper; release the announcement about interest rate hikes; formally raise interest rates; release an announcement about reducing the size of the Fed's balance sheet or formally shrink the balance sheet.
We can reference the previous timeline of the Fed’s withdrawal from QE. From 2008 to 2013, in the wake of the subprime mortgage crisis, the Fed kept interest rates extremely low at 0 - 0.25% and launched four rounds of QE to stimulate the economy. In June 2013, Bernanke, the Federal Reserve chair at the time, stated that QE would be gradually slowed down. Six months later, the Fed gradually tapered its bond purchases at a scale of $10 billion per month and announced the ending of its bond purchases in October 2014. The Fed officially started to hike interest rates in December 2015 and began to shrink its balance sheet from September 2017 until 2018.
Image: Federal Reserve Short-Term Interest Rates (April 2008 to September 2021)
After the subprime mortgage crisis in 2008, the Fed implemented a zero interest-rate policy for seven years.
In 2015, the Fed initiated a hike in interest rates and then restarted the zero interest-rate policy in 2020 in response to the Covid-19 crisis.
Currently, the Fed is buying $80 billion of Treasury securities and $40 billion of agency mortgage-backed securities (MBS) each month, making the total fund size $120 billion. Considering Powell has stressed that he will end bond tapering in mid-2022, it is expected that the Fed will gradually reduce the scale of its bond purchases at a rate of $15 billion to $20 billion in assets per month after the tapering officially begins at the end of this year. In terms of approach, the Fed will probably repeat the measures it took in 2013. Instead of selling bonds on the open market, it will passively wait for the maturity of the medium and long-term bonds that are available while no more bonds are being issued.
Considering the fact that the tapering was discussed for the first time at the end of December 2020, it’s not surprising that the Fed clarified its taper timeline at its September meeting. At the June and July meeting on interest rates this year, the Fed presented its plan for the upcoming tapering with relevant policy tools. In August, Powell mentioned for the first time that "it could be appropriate to start reducing the pace of asset purchases this year". After decreasing the scale of bond purchases to zero and formally ending QE, the Fed will gradually start raising interest rates.
In each meeting on interest rates, 18 members in the Federal Open Market Committee vote to decide on the interest rate policy for the next few years. They produce a "dot plot", which maps out each members' projections for interest rates. In the image below, the horizontal axis indicates the year for which officials gave their forecasts, and the vertical axis is the fed funds rate. It can be seen that half of the members (9) believe that the interest rate will rise in 2022, and the vast majority of the members (17) predict rate increases in 2023.
Learn From History As the Fed Could Taper Soon
In 2013, the Fed tapering triggered panic in asset markets. This was followed by the sharp climb in 10-year U.S. Treasury securities yield and the 16% drop in the S&P 500. This event is known as a Taper Tantrum. Since Treasury securities are backed by the full faith and credit of the United States and there is no call risk. The 10-year Treasury yield can be considered a market-determined risk-free rate of return (nominal rate), which reflects market liquidity. When investors purchase bonds, the future cash flow of the bond is already determined and it is the real-time price of the bond that changes. Therefore, a rise in Treasury yields marks a downtrend in the bond market and can cause a sharp drop in the price of Treasuries. In terms of stock prices, according to the discounted cash flow model (“DCF model”) which is a type of financial model that values a company by forecasting its' cash flows and discounting the cash flows to arrive at a current and present value, an increase in the risk-free rate of return will lead to a decrease in stock price.
Figure: US 10-year yield, Source: Investing.com
Cryptocurrencies are a large emerging asset class, and similar to equity markets. They are inevitably subject to the global macro-financial environment and black swan events. In terms of asset nature, it has been an open question whether Bitcoin should be seen as a risk or a safe-haven asset. From 2017 to 2018, BTC prices showed a positive correlation with gold prices. Moreover, the price movements of Bitcoin(from 2013 to 2018) and gold(from 1976 to 2018) seem to behave in a remarkably similar way. However, since 2019, BTC price has shown a certain negative correlation with the gold price in terms of volatility, which makes Bitcoin a riskier asset.
In this round of quantitative easing by the Federal Reserve, the prices of various assets have risen. Cryptocurrencies (especially Bitcoin) caught the eyes of major institutions as the bull run took off. Considering the US government is about to hit the $28.4 trillion debt ceiling in October, the risk of debt default has led to a sell-off in government debt. with the 10-year Treasury rising above 1.5%. At the same time, Bitcoin rebounded from a low of $41,000 and its price rose by more than 30% within a week.
Conclusion
Taking into consideration that the Fed could taper soon and monetary policy seems to be getting back to “normal”, the entire capital market is bound to see a wave of adjustment. However, unlike 2013, the Fed has reacted maturely in dealing with this financial crisis. The market has clearer expectations for tapering. In addition, the cryptocurrency market is gradually decoupling from traditional capital markets such as stocks and showing independent trends which are not subject to the traditional market. This adds more variables to the crypto world’s response to this round of tapering.
Author: Ashley. H, Gate.io Researcher
*This article represents only the views of the researcher and does not constitute any investment suggestions.
*Gate.io reserves all rights to this article. Reposting of the article will be permitted provided Gate.io is referenced. In all other cases, legal action will be taken due to copyright infringement.
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