Bitcoin (BTC-USD): The February Fed And 6 More Weeks Of Crypto Winter

There is a just ton of news driving sentiment in the digital asset space. On the regulation front Congressman Patrick McHenry, an active digital asset proponent, now has control of the powerful House Financial Services Committee. Pro-crypto amici lawyers are making headlines against the SEC in the courts with the LBRY Credits (LBC-USD), Ripple/XRP (XRP-USD) and Grayscale Bitcoin Trust (OTC:GBTC) litigations. And the contagion from the implosion last May of top algorithmic-style stablecoin LUNA (LUNA-USD) is currently still creating large waves with the Genesis bankruptcy filing and the pressure it puts on its parent, and sector behemoth, the Digital Currency Group.

But despite all the news, Federal Reserve monetary policy should remain the main influencer of Bitcoin (BTC-USD) price in the medium-term. In the graphic below note the close correlation between the interest rate and liquidity sensitive Nasdaq Composite and the Bitcoin price. Since the beginning of Fed tightening early last year, there has been a strong inverse correlation between the technology and digital assets sectors and increases in interest rates and interest rate expectations. Also note from the graphic, there can be a sharp divergence from the correlation around large events like the FTX bankruptcy in November, but that the general linkage still dominates.

The markets liked Chair Powell’s press conference last week and the Nasdaq closed up over 2% on Wednesday with Bitcoin immediately rallying another $700. On the surface there was some dovish pivot to the language in the statements as well as an open recognition that the inflation outlook had substantially improved. But this dovish narrative belies a growing problem; the Fed forecast implies meaningfully higher rates, and for longer, than market participants currently anticipate.

Consider the following inquiry at the press conference from Simon Rabinovitch with The Economist that highlights the “higher” discrepancy:

Rabinovitch – May I ask a further question about the language around ongoing increases that, of course, implies at least two further rate rises? If you look at fed fund and futures pricing, the implication is that you’ll raise rates one more time and then pause. Are you concerned about that divergence or do you think if everything breaks right, is that a plausible outcome?

Powell – I’m not particularly concerned about the divergence, no, because it is largely due to the market’s expectation that inflation will move down more quickly.

Chair Powell’s Press Conference, federalreseve.gov, 2/1/23

During the Q&A Powell also recognized the “for longer” discrepancy and emphasized market expectations for cuts this year may be misplaced.

Again, my forecast and that of my colleagues as you will see from the SEP, and I mean, there are many different forecasts, but generally, it’s a forecast of slower growth, some softening in labor market conditions, and inflation moving down steadily but not quickly. And in that case, if the economy performs broadly in line with those expectations, it will not be appropriate to cut rates this year, to loosen policy this year. Of course, other people have forecasts with inflation coming down much faster, that’s a different thing. You know, if that happens inflation comes down much faster, you know, then we’ll be seeing that and it will be incorporated into our thinking about policy.

Chair Powell’s Press Conference, federalreseve.gov, 2/1/23 (link above)

We will get the next Summary of Economic Projections from the Fed with the March FOMC meeting materials. But, looking back to the December SEP’s dot plot, the median participant is projecting a terminal federal funds rate between 5% and 5.25%. It is important to note that the dot plot also indicates the expectations for year end. So the participants are not anticipating cuts later in the year.

Over the past year the Fed has continually adjusted its policy outlook to be increasingly tight as the “inflation is transitory” narrative proved incorrect. As of December the Fed continued to meaningfully raise their expectations for the terminal rate. Note the dotted lines in the graphic below represent the prior SEP from September of ’22. It would be reasonable for the March data to show Fed expectations have again moved up.

Despite Powell’s case for meaningful additional tightening that is maintained into 2024, the Thursday following the FOMC meeting did not indicate much of a change in market expectations. Looking to the CME FedWatch Tool, market expectations remained more constructive with a peek in rates in June or July at the lower range of 4.75% to 5%.

Note the January Employment Situation from the BLS that was reported Friday did cause a rise in rate expectations. Total nonfarm payroll employment rose by 517,000 during the month, a large beat of the forecast that had called for less than a 200,000 rise. However, it is likely the Fed outlook will also equally incorporate this unexpected strength, and the prior divergence between the Fed and markets remains.

Why The Divergence? A Key Inflation Metric Is Labor Market Dependent

Put simply, investors expect the return of the entrenched dovish monetary policy that has characterized the post-2008 Fed. From 2009-2021 the effective federal funds rate remained below 2.5% and quantitative easing has taken the Federal Reserve’s balance sheet from $1 trillion to $8.5 trillion, with no periods of substantial normalization beyond the relatively small 2018 decrease of about 15%.

Both business leaders and the business media have raised concerns that Fed policy may now be overly restrictive. And there is a growing belief that the Fed should and will pivot. Recall from November when Elon Musk tweeted that Fed policy amplifies the probability of a “severe recession”. A similar example from the recent press conference comes in a question by Steve Liesman of CNBC.

…the three-month annualized PCE is 2.1 percent. And you’ve achieved this without going to your 5.1 percent funds rate, which is what you have penciled in for this year. And you’ve also achieved it without the one percentage point increase in the unemployment rate, which you have penciled in for this year. I’m wondering if you’ve considered the idea of whether or not your understanding of the inflation dynamic may be wrong….

Chair Powell’s Press Conference, federalreseve.gov, 2/1/23 (link above)

Powell himself recognizes the recent reversal in the headline PCE trend. But thinks there is more risk in doing too little rather than going too far.

The inflation data received over the past three months show a welcome reduction in the monthly pace of increases….

I continue to think that it’s very difficult to manage the risk of doing too little and finding out in 6 or 12 months that we actually were close but didn’t get the job done, inflation springs back and we have to go back in. And now, you really do worry about expectations getting unanchored and that kind of thing.

Chair Powell’s Press Conference, federalreseve.gov, 2/1/23 (link above)

Keeping expectations well anchored is a principle for Powell and the Fed. And participants are looking closely within inflation data to insure price increases don’t become entrenched in any of the large components. Relating back to Liesman’s question about apparent strong progress toward lowering inflation with no damage to the labor market, Powell explained his fears.

…we have a sector that represents 56 percent of the core inflation index where we don’t see [dis]inflation yet. So, we don’t see it. It’s not happening yet. The inflation in the core services [ex]housing is still running at 4 percent on a 6- and 12-month basis.

In the other two sectors [goods, housing services] representing, you know, less than 50 percent, you actually, I think, now have a story that is credible, that’s coming together, although you don’t actually see [dis]inflation yet in housing services, but it’s in the pipeline, right?

So, for the third sector, we don’t see anything here. So, I think it would be premature, it would be very premature to declare victory or to think that we’ve really got this.

…the core non-housing services as I mentioned earlier, it’s a very diverse sector… we think [majority] are sensitive to slack in the economy, sensitive to the labor market in a way, but some of the other sectors are not.

…research would show [core non-housing services] is sensitive to slack in the economy and so the labor market will probably be important.

we’re just telling you that we don’t see inflation moving down yet in that large sector. …we got to be honest with ourselves. …we’ll see more persistent inflation in that sector which will take longer to get down.

Chair Powell’s Press Conference, federalreseve.gov, 2/1/23 (link above) [author edited transcript]

The coming months are likely characterized by this resolutely hawkish and careful FOMC that is highly accepting of a weaker labor front. This scenario will be a headwind for interest rate and liquidity sensitive assets like Bitcoin.

Consider Trading Around Core Bitcoin Holdings

Going forward toward the 2024 halving, I expect periods of lower average volatility, a possible retest of the $16k bottom and eventually significant gains, though not the parabolic price appreciation seen during the bull runs. My wide target range for the price through the March ’24 halving event is between $35k and $45k. This is based on prior cycles’ price action during the corresponding period in the cycle and average mining costs, including an expected 40% increase in total network hash rate over the timespan.

Each investor’s particular investing style, risk profile and time horizon differ. But current technical analysis points to a majority probability of a short-term correction. Digital assets may also struggle short-term as market expectations shift in the coming months to align with the Fed’s more hawkish plans to ensure inflation will return to the mandated levels. This is especially likely if we continue to see a healthy labor market, as in Friday’s strong January jobs report, which recall from above is a large driver of Powell’s key, non-housing services inflation metric. Put differently, caution is warranted following the recent run, and a buy the dip opportunity may present in the next few months.

One temporary option for those looking to stay invested, avoid timing and basically maintain their HODL stance in the sector is to change allocation plans for any new funds, as well as redirecting recent gains from higher beta and leveraged exposures. Consider shifting from the Bitcoin miners, Coinbase (COIN), MicroStrategy (MSTR) and Ethereum (ETH-USD) to more direct exposures like the futures-based ProShares Bitcoin Strategy ETF (BITO) and the Grayscale Bitcoin Trust. The Grayscale product is particularly interesting because its current, meaningful discount to NAV may reverse from pending litigation upside or a future redemptions plan. The Grayscale Trust has the added advantage over the ProShares product in that it is holding Bitcoin on-chain rather than through cash-settled derivatives.

My new marketplace service is coming soon. Complete Crypto Analytics is launching in the near future and will provide model allocations for Bitcoin and Bitcoin adjacent names such as GBTC and the miners. Please keep reading my articles here for updates so you can reserve your spot as a Legacy Discount Member. Thank you for following my work.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.