To understand how inflation affects the market, you need to clearly understand the following sequence: high inflation -> rate hike -> expensive dollar -> cheap stocks, cryptocurrencies and all risky assets. Now more below about the reasons.
When inflation increases, central banks such as the Federal Reserve typically respond by raising interest rates in an attempt to control inflation and stabilize the economy. This increase in interest rates trigger bearish reactions in the markets for risky assets.
Higher cost of borrowing: When interest rates rise, borrowing becomes more expensive for both individuals and businesses. This can result in reduced borrowing, lower consumer spending, and decreased business investments. As a consequence, the demand for risky assets, such as stocks and high-yield bonds, may decline, leading to bearish sentiments and a drop in their prices.
Shift to safer investments: Higher interest rates often make safer investments, such as government bonds and other fixed-income securities, more attractive to investors. This is because they typically offer higher yields when interest rates rise. As investors shift their focus to safer investments, the demand for risky assets may decrease, further exacerbating the bearish sentiment in the market.
Reduced corporate profits: Companies may face increased costs due to higher interest rates, as they must pay more to service their debt. This can lead to a decline in corporate profits, which in turn may result in lower stock prices. Additionally, companies that rely heavily on borrowing may find it more difficult to finance their operations, potentially leading to a slowdown in their growth and a negative impact on their stock prices.
Currency fluctuations: Rising interest rates can affect currency exchange rates as well. When interest rates increase, foreign investors may be drawn to that nation’s currency due to the prospect of higher returns on their investments. This can lead to an appreciation of the currency, making exports more expensive and imports cheaper. As a result, companies that rely on exports or operate in industries sensitive to exchange rate fluctuations may experience lower revenues and reduced profitability, which could negatively impact the prices of their stocks and other risky assets.
Increased uncertainty: Higher interest rates can create uncertainty in the market, as investors may be unsure of how the changes will affect various sectors of the economy. This uncertainty can lead to increased market volatility and a bearish sentiment, as investors become more risk-averse and cautious in their investment decisions.
In summary, higher interest rates lead to a higher cost of borrowing, a shift towards safer investments, reduced corporate profits, currency fluctuations, and increased uncertainty. These factors can contribute to a decline in demand for risky assets and a subsequent drop in their prices, as investors seek safety in more stable investment options.
High interest rate and banking crisis
Everything works exactly as described above in normal times. But recently the banking crisis has intervened in the game, and we must take this factor into account.
High rates led to higher cost of borrowing, Shift to safer investments (such as government bonds and other fixed-income securities), reduced corporate profits etc. all these things led to difficulties in the banking sector, after which we saw the fall of several banks and daily news about how governments of different countries intervene in the banking sector in order to stabilize the banking sector.
In turn, this led many to consider the crypto market as a safe haven, and the growth of bitcoin, in my opinion, is connected precisely with this(Although thanks to fud around stablecoins, but that’s not related to this topic).
Conclusion based on the current situation
In conclusion, the impact of high inflation can initially cause a decline in the value of cryptocurrencies, as investors may anticipate higher interest rates and a subsequent drop in demand for riskier assets. However, over time, the potential for a banking crisis and other negative consequences stemming from high inflation could prompt investors to seek safer havens, such as crypto. It is important to note that the initial reaction to high inflation is typically the risk of interest rates rising more than expected, which can lead to a decline in all risky assets, including cryptocurrencies. Nevertheless, as the situation unfolds, cryptocurrencies may experience growth as they are seen as alternative stores of value amidst economic uncertainty.
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