Here’s Why the Cryptocurrency Market Suffered Another Big Drop, Continues to Slump

The Federal Reserve Signals that It May Pull the Rug on the Market

The immediate cause for this week’s selloff was the Federal Reserve. In particular, minutes from the Fed’s latest meeting revealed that it had agreed to accelerate its withdrawal of financial support for markets, which had been buoyed throughout 2020 and 2021 by an unprecedented bond-buying programme and record-low interest rates.

Such stimulus had helped indices such as the S&P 500 and the Dow reach all-time highs, and they had also helped cryptocurrencies break their own records. Now, with the Fed clearly signaling that rates are going to rise and the flow of new money is going to contract, the market is spooked, as indicated by falls in international stock markets that also greeted the news.

As Unigestion investment manager Olivier Marciot told the Financial Times, “Markets are awakening to the end of easy money. We have had a lot of quantitative easing and monetary support, which creates an environment where all assets tend to thrive, and when you remove that it is the reverse. It is a correlation shock where everything is being battered at the same time.”

Pretty much every prominent analyst now expects tightening monetary policy to have a detrimental effect on stocks and, in particular, riskier assets such as cryptocurrencies. Because with interest rates returning to normal levels and the economic outlook seeming shaky (due to rising inflation), investors may prefer safer havens such as bonds and US Treasuries.

“It’s going to be the first time in almost two years that the Fed’s incremental decisions might force investors or consumers to become a little more wary,” said David Schawel, the chief investment officer at Family Management Corporation, who was speaking to the New York Times for an article in which the paper suggested that the Fed “may pull the plug” on stocks.

Writing in his January 6 newsletter to investors, ThinkMarkets analyst Fawad Razaqzada suggested that 2022 “could be a challenging year for crypto bulls,” not least because of rising inflation and the monetary response to such inflation.

“So, paradoxically, it is high levels of inflation that has derailed the rally for both gold and Bitcoin. What investors in these assets need to see is a sharp drop in inflation to deter the Fed from tightening too fast. If that doesn’t happen then we may well see further struggles in both assets down the line,” he wrote.

Absence of Narratives

In the same newsletter, Razaqzada noted that “the bullish momentum has not [been there for the cryptocurrency market] for a couple of months now.” One reason why this is the case is because there’s been an absence of really significant narratives concerning mainstream adoption and/or investment.

Indeed, since Tesla’s February purchase of $1.5 billion in BTC, and since El Salvador’s move in June to make BTC legal tender, neither Bitcoin nor the wider cryptocurrency market has enjoyed truly substantial news.

Admittedly, there was Facebook’s name change to Meta (on October 28), which did boost a number of metaverse-themed coins. However, this was isolated to a small number of cryptocurrencies, which together constitute only the 24th biggest cryptocurrency category, according to CoinGecko. They also remain small in terms of user numbers, with Decentraland, for example, currently boasting only 300,000 monthly active users (the figure is 2.9 billion for Facebook and 2 billion for Instagram).

And without the much-hyped end-of-2021 rally, enthusiasm and bullishness has disappeared from much of the market. Hence, we have a lack of new entrants, and a lack of anything that might prevent holders from selling off their funds and causing the market to slide further.

Overheated Market Cooling Off

Linked to the lack of a new positive narrative, the market is also clearly going through a period of much-needed correction. 2021 may have been a great year for it, but much of its expansion was the result of overexuberance. Put differently, it’s highly likely that rises in 2021 were significantly bubble-like.

For instance, trading volumes for bitcoin derivatives (i.e. futures, traded using leverage in most cases) far exceeds trading volumes for spot bitcoin. In 2021, averages for derivatives reached a peak of around $300 billion in May and stayed above $200 billion for the rest of the year. Spot volumes only just about passed $50 billion at their peak.

Source: The Economist/Kaiko

As we’ve written before, the cryptocurrency market is and has been far too dependent on leverage. This means price rises have largely been the result of people trading with money they don’t have.

Well, now that borrowed money is drying up as positive narratives fade and the macroeconomic environment becomes less favorable. Back in September, the liquidation of around $3.44 billion in leveraged longs caused a big flash crash. Yesterday, only around $133 million in long positions were liquidated, indicating a decline in people bullish enough to take out leverage.

Likewise, data from Coinglass (formerly Bybt) shows that open interest in bitcoin futures and options have both declined significantly since November. This all suggests that the market is now cooling off, with fewer traders willing to take risks.

The Prognosis

Given the gloomy macroeconomic picture, we wouldn’t expect the market to recover substantially for at least several months.

That said, positive narratives may return to crypto by the spring, assuming that Ethereum completes its transition to Ethereum 2.0 and proof-of-stake. This transition is due to take place at some point between the end of Q1 and the end of Q2 of this year, and if it all goes according to plan, it will likely provide the market with some much needed confidence and optimism.

Likewise, Ripple’s case with the SEC is likely to reach some kind of settlement in Q1 of this year too. The available evidence suggests that it has a strong one, so a victory may be another source of very good news for crypto.

Otherwise, the market needs to wait for more adoption stories, whether these be from institutions, corporations looking to add BTC to their balance sheets, big multinationals accepting cryptocurrencies as payment, or from actual nation states. Given that 2021 had its fair share of such stories, we’d be surprised if 2022 didn’t turn up a few of its own sooner or later.