Bitcoin’s decline suggests Fed’s hawkish policy shift is priced in

Bitcoin appears to have digested the U.S. Federal Reserve’s (Fed) impending hawkish or anti-inflation policy adjustment with a significant decline in recent weeks. Analysts said the cryptocurrency could see a relief rally post the Fed decision due later on Wednesday.

The central bank is widely expected to announce a $30 billion reduction in asset purchases starting in January 2022, doubling the pace two months prior in a bid to phase out the $120 billion per month program by March. Further, it is likely to signal two rate hikes in 2022.

The hawkish expectations have built up in response to elevated inflation pressures and Chairman Jerome Powell’s recent decision to retire the word ‘transitory’ from inflation discussions. Monetary policy tightening is typically considered bearish for assets, including bitcoin – a risk-on inflation hedge and emerging technology.

That said, a significant de-risking has already happened, leaving the doors open for a classic “buy the fact” trade or relief rally triggered by a highly anticipated negative announcement.

As seen in the feature image, bitcoin peaked near $69,000 on Nov. 10 after the U.S. consumer price index (CPI) touched a three-decade high of 6.2% in October, but has since dropped more than 30%. The CPI rose to a four-decade high of 6.8% in November.

The dollar index, which tracks the greenback’s value against major fiat currencies like the euro, pound, and yen, has risen over 2% in the past few weeks, hitting a 16-month high of 96.93.

The two-year Treasury yield, which mimics the short-term inflation and interest rate expectations, recently rose to an 18-month high of 0.72%.

Meanwhile, the fed funds futures have pulled forward the timing of the first interest rate hike to May 2022 and priced in at least three hikes for next year.

So, the probability of a deeper sell-off on the Fed announcement is relatively low unless the central bank hints at more aggressive tightening than what’s baked in.

“The Fed is unlikely to come in more hawkish than what the market is expecting,” Joel Kruger, a currency strategist at LMAX Digital, said. “That leaves the balance of risk tilted to the other side.”

“De-risking in anticipation has been extensive. Many already panic sold. Positioning is light. Therefore, if the Fed were to deliver accelerated taper, signal two hikes for 2022, and nothing else, I would expect a rally across asset classes,” trader and analyst Alex Kruger tweeted.

Historical data supports the case for a broader crypto market bounce in the final days of December. “We’ve seen this pattern over the past four years -- where the first 2 weeks of December are very choppy, only to resolve incredibly bullish over the back-half of the month and into the new year,” Jeff Dorman, chief investment officer at Arca Funds, said in a weekly markets note published Monday.

Focus on peak rates

With faster taper and three rate hikes priced in, the focus will be on the Fed’s peak interest rate projection.

There is consensus that the impending tightening hike cycle will see rates peak well below the high of 2.5% observed during the previous cycle dated December 2015 to December 2018.

According to Reuters, “markets are currently priced for a peak of just 1.5%-1.75%, a level that would likely not even top inflation.” Further, bond traders see rates averaging just 1.8% for the next three decades.

So, real or inflation-adjusted returns in the fixed income world are likely to remain negative for a prolonged time, driving yield-hungry investors to crypto. Despite the recent pullback, bitcoin is still up 66% this year.

Bitcoin and risk assets, in general, could take a hit if the Fed’s interest rate projections signal a higher than expected peak. The cryptocurrency was changing hands near $48,500 at press time.