Higher Interest Rates May Be Coming. Here's Why That's Bearish for Crypto.

The May readout of the Consumer Price Index (CPI) landed hot at 4.2% on June 10, marking a three-year high. Now, Federal Reserve policy talk has flipped from the possibility of rate cuts to the increasing probability of rate hikes in the near term, and there may be more energy price inflation on the way thanks to the ongoing conflict with Iran. At the same time, the Crypto Fear and Greed Index, a barometer of crypto market sentiment, reads 21, a level denoting extreme fear, and Bitcoin (CRYPTO: BTC), the sector leader, is down 20% in the last 30 days alone.

This is not at all what a good macro backdrop for crypto looks like. Here's why.

Image source: Getty Images.

Why higher rates squeeze crypto

When the Federal Reserve hikes interest rates to tamp down rising prices, it increases the yield on Treasury bonds, which are among the safest investments around.

Higher Treasury yields raise the opportunity cost of holding non-yielding assets, thereby incentivizing capital to pull back from the riskiest sectors of the market, such as crypto. The May CPI print put that hike risk firmly back on the table. Markets are now pricing in a December hike at nearly 51%, up from practically zero just a few months ago.

The Federal Open Market Committee (FOMC) meets June 16 and 17. If history is any guide, the crypto market will sell off in the days leading up to the Fed meeting, and then, if rates actually increase, it'll be a touch harder for prices to rise for at least a few months thereafter.

But if you hold crypto, don't be overly concerned about this dynamic. In the long run, quality assets will still be able to grow, as their fundamental value exists outside of whatever price the market assigns to them in any given quarter and, eventually, real value gets recognized by the market.

How leading coins might absorb the squeeze

The headwinds from any rate hikes will affect different coins differently.

Ethereum (CRYPTO: ETH) has significant downside exposure. Its decentralized finance (DeFi) ecosystem competes directly with Treasury yields, potentially leading to capital outflows. Ditto for Solana, which tends to bleed when cheap money dries up.

XRP (CRYPTO: XRP) is a wildcard. It has held up better during the current drawdown, and spot XRP exchange-traded funds (ETFs) keep pulling in new capital even while Bitcoin ETFs are seeing outflows.

Bitcoin will probably suffer the least. It is now held by spot Bitcoin ETFs, corporate treasuries, and even government reserves. Reflexive selling on rate hikes will happen, but the institutional holder base is unlikely to be skittish for long.

You should be on the lookout for hawkish language by the new Fed chair, Kevin Warsh, at the June 16-17 meeting. It's unclear precisely what his governance style will be compared with that of recently departed chair Jerome Powell, but all indications point to it being quite different.

And remember, if it sounds like rate hikes are on the way, it might be worth looking for opportunities to buy the resulting dip, if it happens.

Alex Carchidi has positions in Bitcoin, Ethereum, and Solana. The Motley Fool has positions in and recommends Bitcoin, Ethereum, Solana, and XRP. The Motley Fool has a disclosure policy.