You can spend many years in the crypto space but still find traditional finance terms confusing! If you don’t know how quantitative easing works or why the bond market is so important, then this article is for you. We’ll cover the four most important financial terms to help you understand how macroeconomic factors can affect crypto.
Bonds are a type of loan that corporations and governments use to raise money. They have a fixed duration and an interest payment that’s referred to as a coupon. Investors buy bonds because they can earn interest, and when the bond’s duration is up the buyer gets all of their money back.
When investors talk about the bond market, they’re usually referring to United States Treasuries. Treasuries are the largest and most liquid bonds in the world, with an annual trading volume in the hundreds of trillions of dollars.
Although Treasuries come in just about any duration, investors pay the most attention to a few key products, namely the 2 and 10 year notes. The trading activity on these bonds is often used to predict inflation, forecast economic growth and make projections about what the stock market is going to do in the near term.
Given the high rates of inflation we’re currently experiencing, it’s critical to understand the difference between real and nominal rates. Here’s how it works. Let’s say you earn 1% interest in your bank account, That is the nominal rate. However, the latest CPI print tells us inflation is at 8.6% in the US. Subtract the nominal rate from the inflation rate and you end up with a real rate of -7.6%. So your money is earning a nominal 1%, but in reality you’re losing 7.6% in purchasing power every year.
The Federal Reserve
The Federal Reserve, more commonly referred to as the Fed, is America’s central bank. The Fed’s primary purpose is to keep the financial system and economy running smoothly. They do this by pursuing two mandates: keep inflation at a steady level, and unemployment rates low. The Fed has several tools they use to achieve their objectives. They can raise or lower interest rates, and perform quantitative easing.
Quantitative easing, which is usually referred to as QE, means the Federal Reserve buys Treasuries from large commercial banks. When the Fed buys treasuries, they’re trying to do two things. First, they want to drive down interest rates to stimulate the economy. According to standard economic reasoning, lower interest rates lead to economic growth since it’s easier for corporations to borrow money and grow their business.
The second outcome of QE is that the Fed wants to force banks and other financial institutions to invest in the real economy. If bond yields go down, banks might be more likely to lend to businesses to generate the yields they need to earn a profit. Quantitative tightening, or QT, is the opposite of QE. So during QT the Fed sells treasuries back into the market, raising interest rates and putting a damper on economic growth. The Fed will engage in QT if they believe the economy is running too hot and inflation is getting out of control. Hopefully this video has helped increase your understanding of traditional finance, which should in turn help you make better decisions in crypto!