Why Do Federal Reserve Policies Affect Bitcoin Prices?

Basics

Quantitative easing (QE) and quantitative tightening (QT) are essential tools used by central banks to manage economic liquidity. QE involves buying financial assets to inject liquidity and lower interest rates, while QT sells assets to withdraw liquidity and raise rates. This article explores the basics of QE and QT, their origins, the use of shadow mechanisms like reverse repurchase agreements, and their impact on the cryptocurrency market.

Understanding QE and QT

Quantitative easing (QE) involves a central bank purchasing financial assets in the open market to inject liquidity into the economy, thereby stimulating interbank transactions and reducing interest rates.

Conversely, quantitative tightening (QT) is a central bank policy focused on selling financial assets to withdraw liquidity from the economy, aiming to increase interbank interest rates.

Although the Federal Reserve's target interest rate is announced during agency meetings, it is achieved through open market operations. To raise interest rates, the regulator sells assets from its balance sheet to banks and private organizations. To lower rates, the Federal Reserve buys these assets from market players. Ideally, central banks should only trade government bonds. However, in practice, regulators also purchase mortgage loans and even private company securities. Decisions on these operations depend on market conditions and the central bank's objectives.

Origins and Evolution of QE and QT

Quantitative easing (QE) first emerged with the Bank of Japan in response to the early 2000s crisis caused by the collapse of internet company markets, coupled with near-zero interest rates and a prolonged recession. This led Japan's central bank to initiate QE in March 2001. This strategy addressed the issues caused by the near-zero interest rate policy, which hindered economic growth in developed countries. Central banks effectively created new money to repurchase their own government bonds previously sold to commercial banks and other market participants.

The United States launched its first QE in 2008 to counter the global financial crisis. Notably, this coincided with the publication of Bitcoin's white paper by Satoshi Nakamoto. Subsequent rounds of QE in the U.S. occurred in 2010, 2012, and 2020. By April 2022, these measures had enabled the Federal Reserve to acquire nearly $10 trillion in assets. The most significant QE took place during the COVID-19 pandemic from 2020 to 2022, doubling the Federal Reserve's balance sheet to nearly $9 trillion. For context, the U.S. GDP for 2023 was $27 trillion, while the cryptocurrency market's peak capitalization in 2021 was $2.8 trillion. As of May 2024, the U.S. continues its quantitative tightening (QT) policy, initiated in mid-2022. QT involves withdrawing money from the economy by selling the securities accumulated during QE.

Understanding Shadow QE/QT

Direct quantitative easing (QE) and tightening (QT) are not the only tools for managing market liquidity; there are also "shadow" mechanisms that play a significant role.

A prominent example is reverse repurchase agreements (reverse REPOs), which involve borrowing funds secured by collateral securities with an agreement to repurchase them later. This instrument gained prominence after the 2012 crisis and became crucial during the pandemic, with the Federal Reserve's reverse REPO operations peaking at over $2.5 trillion in 2022. These transactions are often used to provide banks with nearly interest-free loans backed by securities. Even during periods of formal quantitative tightening, the Federal Reserve can implement localized shadow QE, effectively injecting liquidity into the market.

The Impact of Monetary Policy on Cryptocurrencies

A common misconception is that the cryptocurrency market operates independently of traditional finance. However, cheap money from the Federal Reserve's direct and shadow QE programs often finds its way into various trading platforms, including cryptocurrencies. Examining the liquidity chart, which encompasses the Federal Reserve's balance sheet, reverse REPO activities, and the U.S. Treasury's operating account reveals a different story.

The red line represents liquidity inflows and outflows managed by the Federal Reserve, the yellow line tracks the S&P 500 index, and the blue line shows Bitcoin's price.

Since early 2020, when the Federal Reserve initiated its QE policy, a clear correlation emerged among these charts. Liquidity injections and withdrawals have impacted both the S&P 500 index and Bitcoin prices. The start of QT and the subsequent withdrawal of funds from markets also influenced asset prices.

Although Bitcoin was designed as an alternative to the traditional financial system, the growing cryptocurrency market has attracted participants from conventional finance, leading to this observed correlation.

Conclusion

The details of quantitative easing (QE) and quantitative tightening (QT) highlight their important roles in shaping global economic landscapes. From their beginnings to their influence on emerging markets such as cryptocurrencies, these monetary policies manage a delicate balance between promoting growth and managing inflation. As central banks refine their strategies in response to changing economic conditions, it's crucial for investors and policymakers to comprehend the complexities of QE and QT.