Fed Preview: How Rate Hikes Could Stimulate Demand for Stablecoins

With the price of bitcoin (BTC) tanking and the U.S. Federal Reserve now moving to tamp down rising inflation, some analysts think dollar-pegged stablecoins could be this year's winning crypto trade.

The Federal Open Market Committee (FOMC), the Fed's monetary policy-setting committee, holds its January meeting starting Tuesday. Traditional and crypto investors will be awaiting what is said during this meeting, likely the last before several interest rate increases are announced during this year.

While other central banks may keep their monetary policy loose, the Fed is expected to tighten in order to slow increasing inflation. The U.S. Consumer Price Index (CPI) rose 7% in December from 12 months earlier, the highest annual inflation rate since 1982. President Joe Biden has said it's “appropriate” for the central bank to “recalibrate” its monetary policy.

The FOMC, which sets the Fed’s monetary policy, holds eight two-day meetings every year. The next one after this week's will be in March.

Many analysts and investors view traditional economic factors like inflation and interest rates as having an effect on bitcoin's price.

Based on futures contract prices on the CME, the bond market predicts the first interest rate hike will take place at the March meeting. Until then, traders predict, the Fed will keep the fed funds rate — that is, the interest it charges banks to borrow from it — in a range between 0 and 25 basis points.

According to a January report by Bank of America, Fed Chair Jerome Powell is also expected to acknowledge at a press conference on Wednesday that every meeting in the near future is “live,” meaning the U.S. central bank’s usual practice of carefully telegraphing the outcome of upcoming meetings might not apply – so rate increases might be less predictable. The last time the Fed raised interest rates was in 2018.

Higher interest rates on dollar-denominated assets will likely increase demand for the dollar and could result in a strengthening greenback in 2022. This could translate this year into higher demand for stablecoins, particularly dollar-pegged stablecoins.

“Stablecoins are a ‘medium’ between fiat currencies like the dollar and cryptocurrencies," said Scott Bauer, a former Goldman Sachs trader who's now CEO of Prosper Trading Academy. "Given that the Fed is likely raising interest rates multiple times this year, which should essentially provide tailwinds for the dollar, stablecoins which are tied to the dollar can also capture this upside.”

With the U.S. dollar (USD) still the world's dominant reserve currency, assets denominated in greenbacks are in high demand. So stablecoins might provide a relatively easy way to gain exposure to USD.

“For the foreseeable future, there will always be demand for dollar assets, which include stablecoins," said Jeff Dorman, chief investment officer at crypto investment manager Arca. "If the dollar strengthens against other currencies, it will make dollar-based stablecoins more attractive.” He added that the growth in stablecoins could continue regardless of the value of the dollar.

The cryptocurrency market is currently experiencing a tough run, with bitcoin (BTC) trading at around $36,303, down over 45% from its all-time-high, and ether (ETH) at $2,398. In contrast, stablecoin prices are designed to be pegged to a fiat currency on a 1:1 basis, including those pegged to the U.S. dollar.

“If global inflationary concerns persist and [stablecoins] become more globally ubiquitous, there's no reason we wouldn't see a continued march upwards for USD stablecoin market cap due to inflows from other nations with struggling currencies,” Sean Farrell, head of digital asset strategy at FundStrat, said. “Ironically, this would result in a more robust crypto ecosystem and increased USD dominance.”

Bitcoin is down about 23% for the year to date and its volatility is still a major concern among investors. Yet, Farrell doesn’t see this as a long-term situation.

“The USD is still losing value against many other asset classes,” said Farrell. “Thus, while some traders might seek near-term shelter in stables, the cause would be macro uncertainty, not so much a preference for the dollar over bitcoin.”