The US Federal Reserve (FED) recently began an effort to reduce its $8.9 trillion balance sheet by halting purchases of billions of dollars of Treasury notes and bonds. The measures were implemented in June 2022 and coincided with the total market cap of cryptocurrencies dropping below $1.2 trillion, the lowest level seen since January 2021.
A similar move occurred with the Russell 2000, which reached 1,650 points on June 16, levels not seen since November 2020. Since this decline, the index has risen by 16.5%, while the total value of the cryptocurrency market has failed to regain the $1.2 trillion level. .
This apparent disconnect between the cryptocurrency and stock markets has investors wondering if the Fed’s expanding balance sheet could lead to a longer-than-expected winter for cryptocurrencies.
The Fed is trying to fight inflation
To stem the economic downturn caused by restrictive measures imposed by the government during the Covid-19 pandemic, the Federal Reserve added $4.7 trillion to bonds and mortgage-backed securities from January 2020 to February 2022.
The unexpected result of these efforts was higher inflation in 40 years. In June, US consumer prices rose 9.1% from 2021. On July 13, President Joe Biden said inflation data for June was “unacceptably high.” Additionally, Federal Reserve Chairman Jerome Powell stated on July 27:
“It is essential that we bring inflation down to our 2% target if we are to have a sustainable period of strong labor market conditions that benefit everyone.”
This is the main reason why the central bank has withdrawn its stimulus activities at an unprecedented speed.
Financial institutions that have excess cash
A “repurchase agreement,” or “reverse repurchase,” is a short-term transaction with the guarantee of a repurchase. Similar to a secured loan, the borrower sells securities for a financing fee under this contractual arrangement.
In a “reverse repo,” market participants lend money to the US Federal Reserve in exchange for US Treasury bonds and agency-backed securities. The lending side includes hedge funds, financial institutions, and pension funds.
If these money managers are not willing to allocate capital for loan products or even extend credit to counterparties, having plenty of cash on hand is not inherently positive because they must provide returns to depositors.
On July 29, the Fed’s overnight repo facility reached $2.3 trillion, near an all-time high. However, holding that much money in short-term fixed-income assets will make investors bleed in the long run, given the current high inflation. The only possible thing is that this excess liquidity ends up in risky markets and assets.
While a standard demand for parking money may indicate a lack of confidence in counterparty credit or even a sluggish economy, for risky assets there is the potential for increased inflow.
Of course, if one thinks the economy is going to go downhill, cryptocurrencies and volatile assets are the last places in the world to seek shelter. However, at some point, these investors will no longer bear the losses by relying on short-term debt instruments that do not cover inflation.
Think of a reverse repo as a “safety tax,” a loss that someone is willing to take with as little risk as possible – the Federal Reserve. At some point, investors will regain confidence in the economy, which will positively affect risky assets, or they will stop accepting returns below the level of inflation.
In short, all this money is waiting on the sidelines for an entry point, whether it is real estate, bonds, stocks, currencies, commodities or cryptocurrencies. Unless hyperinflation magically disappears, some of that $2.3 trillion will eventually flow into other assets.
The views and opinions expressed herein are solely those of the author and do not necessarily reflect the views of Cointelegraph. Every investment and trading move involves risk. You should do your own research when making the decision.