How Economic Policy and Geopolitical Uncertainty Could Affect Crypto Markets

In the ever-evolving landscape of cryptocurrency markets, 2023 has proven to be a year of formidable challenges. As central banks respond to inflationary pressures with rapid interest rate hikes, and geopolitical tensions cast shadows of uncertainty, the cryptocurrency world finds itself at a crossroads.

In this article, we delve into the critical factors influencing the trajectory of cryptocurrency markets: tightening monetary policies, the resurgence of the U.S. dollar, and the lingering specter of inflation. We also examine the evolving role of cryptocurrencies, particularly Bitcoin, in the context of global finance and stability.

Johnny Louey is a research analyst at LTP. This article is part of CoinDesk's State of Crypto Week, sponsored by Chainalysis.

The graph below illustrates the impact of quantitative tightening by the Federal Reserve and European Central Bank in 2023. Quantitative tightening involves the selling of Treasury securities by central banks, which leads to an upward push on yields. This upward pressure on treasury yields is exacerbated by the implementation of aggressive interest rate hikes. Consequently, these yields have reached their peak levels for the year.

With long-dated treasury yields surging above 4%, capital is flowing out of riskier assets like cryptocurrencies and into these safer alternatives, strengthening the U.S. dollar and reducing demand and liquidity in the cryptocurrency markets.

Record Treasury bond yields, observed since 2008, and the steadfast strengthening of the U.S. dollar since July have exerted downward pressure not only on equities but also on cryptocurrencies. The market correction that started in July has been broad-based, coinciding with the DXY (a measure of the dollar’s value relative to other currencies) surging to a yearly high.

Following several bank crises in March 2023, the Fed implemented the Bank Treasury Facility Program (BTFP) to provide support to banks grappling with the devaluation of their treasury holdings and a crunch in liquidity. This measure has helped alleviate the liquidity crisis. Currently, the Federal Reserve's future course remains uncertain as there have been no indications of a pause in Quantitative Tightening or any plans to cut interest rates. Therefore, the lingering concern now revolves around inflation.

The graph below depicts the notable increase in both U.S. gas prices and crude oil prices, reaching their highest levels of the year.

While the ongoing Israel-Hamas conflict hasn't disrupted oil supplies, concerns remain. Oil analyst Reza Falakshahi has cautioned that further escalation could interfere with critical transport routes like the Strait of Hormuz, through which more than a third of global seaborne oil exports pass daily. Any substantial supply shocks from conflicts affecting major oil chokepoints could perpetuate inflation and compel central banks to maintain aggressive interest rate hikes worldwide to combat rising consumer prices.

Presently, the state of the cryptocurrency markets reveals a decline in aggregate trading volumes since the year's outset, reflecting reduced risk appetite among both institutional and retail investors.

The decline in trading volume can indeed be attributed to a combination of factors.

First, the intensified crackdowns and charges by the SEC against the cryptocurrency industry have created a sense of regulatory uncertainty, causing some market participants to adopt a more cautious approach and reduce their exposure.

Second, the implementation of restrictive monetary policies has led to a capital outflow from the riskier cryptocurrency markets to safer financial instruments.

Lastly, the presence of growing geopolitical uncertainties has created risk aversion, prompting investors to reduce their exposure to potentially immature assets like cryptocurrencies.

While some argue that bitcoin may eventually function as a store of value similar to gold, it has yet to establish itself as a universally accepted safe-haven asset class. Increasing institutional adoption for cryptocurrencies globally has led to bitcoin speculation outweighing mainstream usage as a store of value.

Bitcoin's demand seems primarily driven by speculative activity rather than fundamentals-based investment behavior, as evidenced by the significant dominance of derivatives trading over spot trading on cryptocurrency exchanges (the average derivatives trading volume is approximately four times that of spot trading volume in 2023). Recent price surges have been predominantly fueled by retail fervor and volatility plays, rather than stable institutional demand. Bitcoin's potential as a broad-based safe haven remains uncertain without universally recognized regulations and use cases akin to traditional currencies and stores of value.

In the short term, macroeconomic and geopolitical factors suppressing speculative flows are expected to continue limiting cryptocurrency market activity and volatility. The SEC has repeatedly delayed high-profile Bitcoin ETF applications, obstructing mainstream adoption paths. Regulatory approval is crucial for Bitcoin to become an institutional investment vehicle and a true safe-haven asset for global investors. Widespread institutional recognition and participation are essential for reducing reliance on speculative flows and enhancing its viability as a portfolio diversifier during periods of volatility.