Why Bitcoin Could Outperform If the Federal Funds Rate Changes

In every market, price is one of the main signals, and for the U.S. dollar itself, that signal is the federal funds rate, which is the short-term interest rate the Federal Reserve targets for overnight lending between banks. As you've probably heard, the Fed's target influences a wide spectrum of borrowing costs, from corporate credit lines to mortgages, and it sets the starting point for yields on relatively safe assets like Treasury bills.

When that rate falls or is persistently low, it tends to have pretty positive implications for the prices of cryptocurrencies, especially Bitcoin (CRYPTO: BTC). Here's why.

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The cost of money is a big deal for this asset

When the Fed cuts rates, cash and short-term government debt become less rewarding to hold. At the same time, it becomes cheaper to borrow, whether you are a hedge fund, corporation, or household. In low-rate environments, both financial institutions and individuals tend to shift some capital from safer assets into riskier ones in search of higher expected returns.

We've already recently seen what that combination looks like in practice. In March 2020, as the pandemic hit, the Fed cut the federal funds target range to between 0% and 0.25%. During the next 12 months, Bitcoin's price soared by 443%, though its halving in May 2020 likely had something to do with the increase as well.

The flip side of the story is just as instructive. As the Fed shifted from near-zero rates to a rapid tightening cycle starting in 2022, lifting the target range above 4% by late that year, investors pulled back from risk across the board, and Bitcoin suffered enormously.

Today, Bitcoin trades in the low $90,000s. The Fed has already shifted from the peak federal funds target of 5.25% to 5.50% down to a range of 3.75% to 4% as of late October, with some officials signaling that monetary policy could be moving into an even less restrictive phase next year. More rate cuts are probably on the way.

The next question is how much further easing of interest rates would actually matter for coinholders.

What's coming next?

If the Fed does end up cutting further, the benefit to Bitcoin is that lower short-term yields will reduce the appeal of parking large sums in cash or very short-dated Treasuries. Again, when risk-free rates fall, a meaningful share of investors reallocate their capital toward assets with higher expected returns, even if they are more volatile. Bitcoin now sits squarely in that riskier but potentially higher-return bucket, and, critically, it's now easier than ever for mainstream investors to own, thanks to the existence of spot Bitcoin exchange-traded funds (ETFs).

Assuming the Fed trims rates again and the economy muddles through without a deep recession, there is a plausible path where more pension plans, asset managers, and corporations justify small Bitcoin allocations as part of their search for return in a lower-yield world. However, treating rate cuts as an automatic green light for Bitcoin is a mistake.

Central banks usually cut their rates aggressively for a reason. That reason is typically unpleasant, because it's often as simple as encroaching economic slowdown that the central bank aims to counter with cheaper borrowing costs. If the next leg of easing arrives alongside a sharp downturn or a financial crisis, and it might, investors could easily stampede into cash and high-quality bonds even as yields fall, hurting risk assets like Bitcoin across the board.

So, the federal funds rate should therefore be viewed as an important piece of context rather than as a high-signal investment metric.

Bitcoin could indeed outperform strongly under the right conditions, of which an accommodating Fed rate would be a big part. But the main point of the asset is that it's increasingly scarcer and scarcer over time, and that mechanism is what makes it a good purchase, regardless of what the Fed does in any given period.

Alex Carchidi has positions in Bitcoin. The Motley Fool has positions in and recommends Bitcoin. The Motley Fool has a disclosure policy.