Impact of Lower Interest Rates on Digital Assets
- Jock Percy, PhD, Lightning Capital General Partner
Interest rates serve as one of the most significant tools influencing capital flow, risk appetite, and asset valuations. Fed Chairman Jerome Powell is likely to lower interest rates by 25bps to 50bps. Bloomberg Media summed it up nicely “Markets Hinge on Powell Emulating Greenspan’s Soft Landing”. Former Chairman Alan Greenspan’s playbook back in 1995 averted a recession with the market rallying prior to his critical announcement. Twenty years on we live in a more complex and connected world, where high speed global markets, social media sentiment and geopolitical influences have amplified market volatility. The effects of lower interest rates extend beyond traditional markets, increasingly affecting digital assets as the digital asset market matures, understanding how a lower interest rate environment influences this new asset class is crucial for investors.
Increased Appetite for Risk
Lower interest rates generally drive investors to seek higher yields in riskier assets such as equities as returns are diminished on risk-free assets, such as T-Bills and money market funds. This dynamic also plays out in the digital assets space. When interest rates are low, the opportunity cost of holding riskier assets decreases, making digital assets more attractive for investors looking for higher returns. This increased risk appetite can lead to significant capital inflows into the digital assets market, potentially driving up valuations.
For example, during periods of low interest rates following the COVID-19 shut-down, Bitcoin and other digital assets saw massive inflows of capital from both retail and institutional investors. Bitcoin has increased in price 10x, denominated in USD, and a period marked by low interest rates and expansive monetary policy. Bitcoin also entered this period with overweight market dominance, and the same is reflected now with Bitcoin at 58.10% market dominance at time of writing.
Lower Borrowing Costs and Leverage
In a lower interest rate environment, borrowing costs decrease, which can encourage the use of leverage in the digital assets market. Investors may take advantage of cheaper credit to purchase more digital assets, thereby amplifying their potential gains, However investors must take note of the risks here as poorly timed leverage can lead to outsized capital losses as was the case for so many investors and funds on August 5th when the Bank of Japan hiked rates for the second time this year. This led to significant unwind of the multi-Trillion dollar carry trade where borrowers at very low rates in Japanese Yen buy assets in other markets to generate yield. Leverage has become increasingly prevalent in the digital assets market, particularly through decentralized finance (DeFi) platforms, where investors can borrow against their digital asset holdings. This is part maturation and part speculation.
What we find very interesting is how lower cost capital can also spur innovation within the digital assets ecosystem. Startups focused on blockchain technology and decentralized finance may benefit from easier access to funding, leading to the development of new products and services. The Lightning Venture Fund has taken particular advantage of capital investment in blockchain and web3-related sectors and looks forward to a lower interest rate economy when investors seek higher returns from emerging technologies.
Inflation Concerns and Store of Value
Low interest rates are often accompanied by expansionary monetary policies, such as quantitative easing, which can raise concerns about inflation. The US administration and Federal Reserve may think they have reigned in inflation, but our view is the reduction in inflation may be attributable to a number of other factors including; anachronistic unemployment reporting, and production efficiency, and even more importantly technological innovation. In this environment, digital assets perceived as stores of value see increased demand. Example; Bitcoin’s fixed supply of 21 million coins is a core aspect of its appeal as an inflation hedge. Similarly, other digital assets with deflationary or fixed-supply models, like Ethereum after the EIP-1559 upgrade, can become more attractive to investors wary of inflation and their dominance can drag-along the total digital asset market.
The growing narrative of digital assets as a hedge against inflation could further fuel institutional adoption. Companies and institutions that seek to protect their balance sheets from potential currency debasement may increasingly turn to digital assets as part of their long-term strategy. This institutional adoption, in turn, can bring more legitimacy and capital into the market, driving further growth.
Market Pricing in Rate Cuts
Our research suggests the market has priced a 100% probability 25bps rate cut during the upcoming Federal Reserve meeting in September. Following this there are likely future rate cuts of 150bps to 200bps in 2025. This anticipation of rate cuts reflects broader economic concerns and the Fed’s response to slowing growth and inflation management.
The anticipation of lower rates further supports the ongoing investment thesis for digital assets as investors adjust their portfolios to accommodate expectations of a low-rate environment. With traditional yields compressed, digital assets, particularly those with a strong store-of-value proposition, become even more attractive.
Volatility and Liquidity Concerns
Despite the positive impacts of lower interest rates, investors should remain aware of the increased volatility, and lower interest rates could exacerbate this volatility if speculative investment increases significantly. While capital inflows may boost asset prices in the short term, any rapid change in interest rate policy or macroeconomic conditions could lead to sharp corrections.
Additionally, liquidity remains a concern. While the digital assets market has grown substantially, it is still relatively small (compared to traditional financial markets. A surge of investment driven by lower interest rates could create liquidity challenges, particularly in smaller or less established digital assets.
Conclusion or TLDR (too long didn’t read)
Lower interest rates have complex and multifaceted effects on digital assets. To the upside, they often disproportionately stimulate investment and innovation, as well as increase the attractiveness of digital assets. The downside is heightened volatility and liquidity risks. As the digital assets market continues to evolve, understanding the broader macroeconomic environment and its potential impact is crucial for investors and 24/7 portfolio management is necessary.
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Sources:
1. Bloomberg. “Markets Hinge on Powell Emulating Greenspan’s Soft Landing” https://www.bloomberg.com/news/articles/2024-09-17/markets-hinge-on-powell-emulating-greenspan-s-soft-landing?srnd=homepage-americas
2. Coindesk. "How Lower Interest Rates Are Boosting Bitcoin Prices." [Coindesk](https://www.coindesk.com/).
3. CNBC. "Bitcoin Soars as Investors Flock to Digital Gold Amid Low Rates and Inflation Concerns." [CNBC](https://www.cnbc.com/).
4. DeFi Pulse. "The Rise of Leverage in the DeFi Market." [DeFi Pulse](https://defipulse.com/).
5. PitchBook. "Venture Capital Investment in Blockchain Surges Amid Low Interest Rates." [PitchBook](https://pitchbook.com/).
6. Ethereum.org. "Ethereum's EIP-1559 Upgrade and Its Impact on Inflation." [Ethereum.org](https://ethereum.org/).
7. Bloomberg. "Markets Price in 100% Probability of Fed Rate Cut in September." [Bloomberg](https://www.bloomberg.com/).
8. The Block. "How Lower Interest Rates Are Driving Institutional Investment in Crypto." [The Block](https://www.theblockcrypto.com/).