Fed preview: Bitcoin investors to look past jumbo rate hike

With risk assets, including Bitcoin, under pressure ahead of Wednesday's pivotal Federal Reserve (Fed) meeting, pundits think markets have already incorporated a super-sized rate hike.

So the focus will be on what the Fed says concerning the persistent core inflation, (core inflation strips out the energy and food components), and the labor market and demand conditions that have remained stronger than policymakers judged in July.

"The theme for tomorrow to me is not about 75 [basis point hike] or 100, even though I am in the 75 camp. The theme for tomorrow is that the Fed thought the economic weakness we saw in Q2 was going to assist them in getting inflation back to target and they no longer have confidence," Jon Turek, author of the Cheap Convexity blog, wrote in a note to subscribers Tuesday.

While the Fed saw evidence of a slowing economy at its July meeting, the data released since then suggests otherwise. Notably, the jobs market has remained firm, keeping wages higher. The August consumer price index (CPI) figure released last week revealed that sticky inputs like rents and services are preventing inflation from cooling.

Turek added that the bigger thing to watch for is where Fed Chairman Jerome Powell thinks the bank stands in getting inflation back to 2% through tightening-induced economic pain.

"The hawkish risk for tomorrow is that he now thinks we are still pretty early on," Turek noted.

That would imply a hawkish-for-longer stance, disappointing investors expecting rate cuts or renewed liquidity easing in 2023 and may deepen the crypto bear market. Bitcoin's (BTC) market value has declined nearly 60% this year, predominantly due to the so-called Fed tightening.

Josh Olszewicz, head of research at digital asset fund manager Valkyrie Investments, said, "the Fed will probably raise rates 75 basis points this week while issuing forward guidance on raising rates at a smaller clip for November and December meetings. Likely at 50 bps each. Next year we should see a few 25bps hikes."

"This isn't a change in direction from Fed tightening. This is a more to say that they are beating inflation but not quite done yet, as midterms elections are coming," Olszewickz told CoinDesk, adding that markets will remain mostly risk-off until the Fed either pauses tightening or turns to rate cuts.

Hawkish expectations leave the door open for a relief rally

Since last week's CPI release, markets have seen hawkish repricing of Fed expectations.

The interest rate currently stands between 2.25% to 2.5% and the current betting is for the borrowing cost to peak around 4.5% – a significant upward revision from the pre-August CPI pricing of 4%. Further, bitcoin and ether have declined by 15% and 20% since the CPI release, and the S&P 500 has slipped by 4.5%.

So if the interest dot plot – a graphical representation of each Fed official's projection for the benchmark interest rate – and Fed comments match market expectations, risk assets will likely bounce.

"Expectations are very hawkish and the Fed can come out just as expected and still be more dovish than expected," Brad McMillan, chief investment officer and a managing principal at Commonwealth Financial Network, wrote in the Fed preview. "That limits the market downside from this meeting and just may provide some upside going forward."

While wage growth remains a problem for the Fed, inflation expectations, which can become self-fulfilling, have cooled since the July meeting. Further, the housing market seems to be slowing. (Rising housing prices lead to higher rents and rent contributes to inflation.)

If the Fed focuses on the drop in inflation expectations and housing market slowdown instead of the stick core inflation, risk assets may take it as a dovish surprise and chart a relief rally.

"There are signs that inflation may be peaking, as high-frequency housing data is softening. The real question for this Fed meeting is whether it notices – and chooses to acknowledge – those trends. If so, that would likely be interpreted as a surprise on the dovish side in its comments. And that would rattle expectations," McMillan wrote.

According to Cheap Convexity's Turek, the Fed will look past inflation expectations and focus more on getting the benchmark interest rate to a level that "equilibrates the demand and supply across the whole economy in a way that is consistent with their 2% inflation target."