Fed Outlook: Hawks Don't Let Go? Bitcoin May Be Triggered by a "Healthy Pullback"

The crypto market has started 2023 on a positive note, with Bitcoin's nearly 40% price gain outperforming traditional risk assets. As Wednesday's important Federal Reserve (Fed) interest rate decision announcement approaches, crypto market strategists warn that Bitcoin may break its year-to-date gains as Fed Chairman Powell is likely to stick to his hawkish rhetoric at the press conference, but such a pullback will be "short-term and healthy."

After a 425 basis point (bps) rate hike last year, U.S. economic data for December showed that inflation has cooled, with the employment cost index, an important measure of wages, showing a 1% increase in the fourth quarter, lower than the Dow Jones' 1.1% estimate. The market expects the Fed to slow its tightening pace to 25 basis points on Wednesday, in other words, a 25 basis point rate hike has been priced in by the market. Investors will focus on whether Powell will acknowledge the recent weakness in inflation and economic activity and signal a pause in tightening policy, which will increase market hopes for an early shift to easing policy.

The Fed's long-term inflation target is 2% annually, and Powell has said in the past that he needs to see inflation move lower in a meaningful way before the Fed would consider pausing rate hikes.

As of the close of U.S. stocks on Tuesday, the Dow Jones Industrial Average rose 0.63%; the S&P 500 rose 0.91%, the best January gain since 2019; and the Nasdaq Composite rose 1.19%. Bitcoin rose 1.6% to around $23,115. Ethereum rose 1% to around $1,573.

Analysts believe that a premature shift in the central bank's policy is unlikely as the recent rise in stocks and bonds and the decline in the dollar have eased pressure on capital markets for the first time since April and weakened the Fed's efforts to respond to price pressures by tightening credit standards.

Nauman Sheikh, head of finance at crypto asset management firm Wave Financial, commented: "There is a high probability that Powell will become more hawkish and re-tighten financial conditions at the press conference. As a result, we could see a healthy short-term correction in cryptocurrencies and all risky assets."

Sheikh added that despite the Fed’s repeated warnings that interest rates will “remain higher for a longer period,” the market has gotten ahead of itself in pricing in a Fed pivot.

A market strategist with the Twitter username The Carter also warned that as the Fed meeting approaches, Powell will speak in a tougher way than the market currently expects on Wednesday, and a "massacre" of risky assets, including the cryptocurrency market, may become a reality. He believes that this will lead to a sharp sell-off of all risky assets, including Bitcoin and most other digital assets. He wrote in a tweet: "On February 1, the market will see 'blood', and Powell will re-tighten financial conditions by forcing a positive rate cut."

The Federal Reserve is scheduled to announce its latest interest rate decision at 2:00 PM EST (6:00 AM GMT) on Wednesday, with most analysts expecting a 25 basis point rate hike. This is also what the market is pricing in, with CME's FedWatch tool estimating a 98.1% chance of a 25 basis point rate hike.

Chris Weston, head of research at Pepperstone, said in his weekly market report that financial conditions have recovered to the point where Powell is likely to say the level of easing is "unwarranted," which would push down risk assets including technology stocks and cryptocurrencies.

“At this juncture, the Fed seems unlikely to be dovish, so the risk is for a hawkish Fed – although that is expected – and in the market where leveraged funds are short the dollar (spot market), the risk is slightly skewed to the upside for the dollar, which means lower Nasdaq and gold prices,” Weston wrote.

“Weekly puts are popular among block traders, but there are no records of long-dated monthly puts,” Griffin Ardern, a trader at crypto asset manager Blofin , told CNBC. That suggests caution has seeped into the market ahead of the meeting, boosting demand for short-term puts, or bearish bets.

A quick bull market recovery is possible?

The Powell-induced pullback in expectations could be short-lived as markets have recently become resilient to the Fed’s hawkish rhetoric.

Earlier this month, several Federal Reserve officials warned that interest rate hikes were likely. Despite this, Bitcoin has still risen 40% this month, and riskier cryptocurrencies such as gaming tokens have seen even bigger gains.

Macro investor James Choi tweeted: “I expect the Fed to raise the funds rate by 25bps (already priced in) and have Powell speak hawkishly, but this is smokescreen, the market is forward-looking and will start pricing in a ‘pause’ in March when the S&P 500 hits 4500.”

Choi added: "If the market had believed Powell first, the S&P would not have reached 4,000 points and seen such an easy financial environment."

Earlier this month, several Federal Reserve officials warned that interest rate hikes were likely. Despite this, Bitcoin has still risen 40% this month, and riskier cryptocurrencies such as gaming tokens have seen even bigger gains.

Derivatives market data showed that the slope of longer-duration call options (a measure of the cost of call options relative to put options) remained biased towards call options. Griffin Ardern said: "The reason for this sentiment in the market is that a 25 basis point rate hike has been basically digested, and investors are more inclined to believe that Powell's hawkish speech is a bluff."