How does the Federal Reserve's interest rate cut affect on-chain lending?

Original author: https://substack.com/@ethanyish&https://substack.com/@hannahzhang9
Original compilation: Deep Tide TechFlow

The Federal Reserve cut interest rates this week and hinted at further easing in the future. Almost all mainstream crypto news headlines convey the same message:

Lower capital costs → Increased liquidity → Bullish on cryptocurrencies.

But the reality is more complex. The market has already priced in the expectation of rate cuts, and the inflow of funds into BTC and ETH has not seen an immediate surge.

Therefore, let’s not stay on the surface but examine how rate cuts affect a part of DeFi—lending.

On-chain lending markets like Aave and Morpho dynamically price risk rather than relying on directives from regulatory bodies. However, the Fed's policy provides important context for this backdrop.

When the Federal Reserve cuts rates, two opposing forces are at play:

1) Reverse effect: Fed rate decrease → On-chain yields increase as people seek uncorrelated assets

As capital seeks yields outside of traditional government bonds and money market funds, it may flow into DeFi, thereby driving up utilization and increasing on-chain rates. If we compare the annualized yield (Supply APY) of USDC on Aave with SOFR (Secured Overnight Financing Rate), we can see this trend gradually emerging before the Fed's rate cut in September.

Source:++Allium++

We also see this situation occurring as the DeFi lending-supply yield spread narrows.

Taking Aave's USDC lending situation on Ethereum as an example, in the days leading up to the Fed's rate cut announcement, the lending-supply yield spread gradually narrowed. This was mainly due to more capital chasing yields, supporting a short-term reverse effect.

Source:++Allium++

2) Direct correlation: Fed rate decrease → On-chain yields also decrease as alternative liquidity sources become cheaper

As the risk-free rate declines, the cost of alternative liquidity sources, such as cryptocurrencies, also decreases. Borrowers can refinance or leverage at a lower cost, thereby pushing down both on-chain and off-chain lending rates. This dynamic typically persists in the medium to long term.

We will see signs of this in the forward yield market data.

Pendle is a forward yield market in DeFi where traders can lock in or speculate on future DeFi annual percentage yields (APY). Although Pendle's expiration dates do not perfectly align with traditional benchmark rates, they are very close to SOFR, allowing for valuable comparisons—such as those in late September and late November.

On these dates, the 1-month SOFR rate was approximately 4.2% (September) and 3.9% (November). The implied sUSDe yield for similar terms on Pendle is significantly higher (14.6% and 8.3%, respectively). However, the shape of the yield curve tells the whole story. Like SOFR, Pendle's forward yields are also declining as expectations of further easing by the Fed are digested.

Source:++Allium++

Key point: Pendle's movement aligns with the direction of traditional interest rate markets but at a higher benchmark. Traders expect that as macro policies change, on-chain yields will decline.

Conclusion: The impact of the Fed's rate cut on the crypto market is not as simple as the headlines suggest

Rate cuts do not merely impact the cryptocurrency market (just as they typically affect the stock market in traditional capital markets). Rate cuts also bring various effects—declining on-chain yields, narrowing interest rate spreads, and changes in the forward yield curve—that ultimately shape liquidity conditions.

Beyond lending, we can further explore how the Fed's rate cuts impact the cryptocurrency market, such as how the circulation of stablecoins will change with the decline in issuer yields or real yields leading to increased ETH staking inflows.

By combining real on-chain data, we can move beyond the headlines and truly understand how macro policies permeate the crypto market. ```