Institutional Top-of-Mind #17

Keep up with the top industry updates as we present bi-weekly market insights that are valuable to traders in the institutional space.

In this week's edition, we explore the Federal Reserve's efforts to prevent stagflation by holding interest rates steady for the rest of 2024, and what that means for cryptocurrency prices. We will also look at what institutional investors can do to mitigate risk during this period of heightened volatility.

TL;DR

• The Federal Reserve (the "Fed") maintains a fine balance in providing a soft landing for the economy and preventing stagflation. As it is hard to keep inflation below 2%, the Fed would be taking a hawkish stance by reducing rate cuts to just once this year.

• Cryptocurrency prices might experience short-term volatility as investors seek safer havens like U.S. treasuries. The long-term impact on crypto remains unclear, but utility-driven projects with real-world applications may be less susceptible to fluctuations.

• Regarding derisking methods, institutional investors can leverage hedging strategies like diversification, options, and futures contracts to help mitigate portfolio volatility.

In crypto, where volatility is never far away, interest rates are pivotal in shaping trading behavior and market trends. With the Fed seemingly narrowing down rate cuts to just one by year end despite claiming three rate cuts last December, there's a sense of unease in the air as traders begin to adopt a more conservative approach and favor risk-free assets like U.S. Treasuries and high-yield savings accounts.

For institutional investors, the justifying of higher rates over extended periods is of particular significance, since it can directly impacts the decision to execute hedging strategies and overall fund allocation. We'll examine this complex regarding the relationship between high interest rates determined by the Fed and cryptocurrency prices.

The impact of higher rates for longer

The Fed's higher for longer strategy of maintaining higher interest rates for an extended period presents a complex economic landscape. From wage-price spirals to rampant spending, the attempt to curb inflation with high interest rates can have the following consequences outlined below.

Stagflation risks

(Source: TradingView)

Raising rates combats inflation by discouraging excessive borrowing and the use of leverage. However, this comes with the downside of possible stagflation, which involves stagnant growth and persistently high inflation. Given the current economic conditions, the Fed may only agree on one rate cut in 2024, this suggests overall caution towards easing ‌tightened monetary policy and prioritizing inflation control. Such caution aims to avoid repeating the 1970s, where inaction caused a period of stagflation.

Knock-on effects on growth and employment

(Source: Federal Reserve Economic Data)

While controlling inflation is crucial, it comes at a cost since higher interest rates slow down economic growth. This is something the Fed should address, as high rates are pressuring debt-laden companies and discouraging growth-related spending. Such was the case in the 1980s, when Federal fund rates reached 20% under the leadership of then-Fed chair Paul Volcker. This severe hike resulted in unemployment that soared to almost 11%.

Long-term impact on cryptocurrency valuations

Traditionally, asset valuation models heavily rely on discounting future cash flows. Higher interest rates directly impact these discount rates, potentially leading to lower valuations for assets that promise future returns, including some cryptocurrencies. However, for certain cryptocurrencies with utility functions, the long-term impact of higher rates might be less pronounced. It's largely why projects like Ethena and Uniswap that offer yield generation to combat valuation scares are increasingly popular. While the long-term viability of these yield generation strategies requires further analysis, it highlights the crypto space's willingness to adapt to challenges posed by the Fed.

Potential risk mitigation opportunities

1) Diversification

Spreading investments across different asset classes can help mitigate risk. This could include allocations towards large caps like Bitcoin and Ether that offer a relative degree of safety, utility tokens for DeFi protocols and oracle networks, that feature real-world applications, and stablecoins so investors can benefit from yield-generating protocols that also offer price stability.

2) Hedging with options

This strategy involves using options contracts to hedge against potential price declines or even make gains from them. Here are two common option strategies for hedging:

• Put options: Purchasing put options protects holdings against significant price drops and is a popular way for traders to hedge large crypto positions without the need to unwind them.

• Covered calls: The covered call strategy can generate passive yield in the form of call premiums but limits potential upside if crypto prices rise significantly.

3) Futures contracts hedging

Entering into short futures contracts allows traders to hedge against a decline in crypto prices and is similar to hedging your holdings with puts, since a futures contract locks in a seller's preferred selling price.

Conclusion

The Fed's higher for longer approach to interest rates presents a complex challenge for cryptocurrency traders. While short-term volatility is likely, long-term outlooks depend on several factors, including the Fed's effectiveness in controlling inflation, continued adoption of utility-driven crypto projects, and the emergence of inventive methods to mitigate the impact of higher rates. Institutional investors who can navigate this evolving landscape, apply risk mitigation strategies, and identify cryptocurrencies with real-world use cases, may be well-positioned to benefit from the long-term potential of this asset class.

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