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History suggests that the cryptocurrency market is about to skyrocket due to this little-known fact
History doesn’t always repeat itself, but if it rhymed, it would mean big things for cryptocurrencies.
Things in the world of cryptocurrencies are looking up. After a brutal crypto winter, many cryptocurrencies are at or near all-time highs and the future finally looks bright again.
Yet it will likely get much brighter for one key reason: Central banks around the world are starting to cut interest rates.
The two might seem unrelated, but the links between central bank actions and cryptocurrency market behaviors run deep. For investors, this represents an interesting opportunity. A new wave of liquidity could soon be injected into the market, potentially setting the stage for a major cryptocurrency boom.
Image source: Getty Images.
Central banks start cutting interest rates
In recent days, the European Central Bank (ECB) and the central banks of Canada, Switzerland and Sweden have cut their key interest rates. These changes followed some of the most aggressive rate hikes in decades, implemented by banks in an attempt to contain soaring inflation.
While the American Federal Reserve has not yet started cutting rates, there is growing optimism among market watchers that it will do so by the end of this year. Given that the United States is still the largest economy in the world, this potential policy shift is seen by many as the final domino that must fall to usher in a more favorable environment for risky assets like cryptocurrencies.
Why interest rates matter for cryptocurrencies
At first glance it might seem that interest rates and cryptocurrencies exist in completely separate realms. Cryptocurrencies operate on decentralized networks with their own monetary policies. However, they are inextricably linked to the broader economy.
Cryptocurrencies are a so-called risky asset class, meaning they tend to perform well when investors are generally more willing to accept greater risks in the pursuit of profit. This typically happens during periods of high liquidity, when money is cheap and plentiful. For such a scenario to happen again, interest rates will have to be cut.
To understand why central bank interest rate cuts will benefit cryptocurrencies, it may be helpful to understand the impact of rising interest rates. When central banks raise interest rates, borrowing becomes more expensive, which tends to reduce the amount of money circulating in the economy. High interest rates also make low-risk interest-bearing assets more attractive, further reducing the amount of money spent on riskier assets.
Conversely, when interest rates fall, financing costs decrease and liquidity increases. Lower interest rates also reduce the attractiveness of savings accounts and bonds. With excess capital floating around, this liquidity typically finds its way into various asset classes, including stocks, real estate, and yes, cryptocurrencies.
Historical evidence
We don’t have to look too far back to see evidence of how powerful the impact of lower interest rates can be on the cryptocurrency market. In 2020, central banks around the world cut interest rates to near zero in response to the economic fallout from the COVID-19 pandemic. This resulted in an unprecedented injection of liquidity into the global financial system.
The result? The cryptocurrency market has grown from around $190 billion to over $2 trillion. Bitcoin (Bitcoin -0.06%), the leading cryptocurrency, saw its price rise from around $7,000 in early 2020 to nearly $69,000 by November 2021.
One of the most impressive examples to emerge from the 2021 bull market was Solana (SOL 1.47%). Riding the wave of increased liquidity (and a fair amount of speculation), in less than two years, it jumped by more than 25,000%.
Stay disciplined amid the boom
While this round of rate cuts won’t be as dramatic as those in 2020, they should still have a significant advantage over cryptocurrencies. And as is common in cryptocurrency bull markets, this means that some obscure cryptocurrencies will start to post astronomical gains.
However, while it is easier said than done, it is crucial for investors to maintain a balanced perspective and not get overwhelmed by the hype of speculation: most of these cryptocurrencies are simply not good long-term investments.
To successfully navigate this upcoming phase, investors will need to remain disciplined and focus on blue chip cryptocurrencies with proven track records and strong utility. Bitcoin and Ethereum (ET -0.18%), for example, meet this criterion.
Although this strategy may not be as glamorous as investing in trendy things meme coinsit is one of the few proven strategies that offers investors the kind of returns that only cryptocurrencies can produce.
RJ Fulton has positions in Bitcoin, Ethereum and Solana. The Motley Fool has positions and recommends Bitcoin, Ethereum and Solana. The Motley Fool has a disclosure policy.