Fed Preview: As Crypto Market Sees Smaller Rate Hikes From December, Major Banks Warn 'Slower Doesn't Mean Lower'
Risk assets, including cryptocurrencies, have recently found a footing on hopes that the Federal Reserve (Fed) will pivot away from jumbo interest rate hikes from December to end the so-called liquidity tightening sooner than expected and signal the same at its Nov. 2 meeting.
However, major investment banks believe that the Fed could keep the doors open for continued jumbo rate hikes and a potential switch to smaller rate hikes would not necessarily imply an early end of liquidity tightening.
The Fed has raised the borrowing cost by 300 basis points (bps) this year, roiling risk assets. The central bank is expected to deliver its fourth 75 bps hike on Wednesday, lifting the borrowing cost to the 3.75%-4% range. It could signal a 50 bps step down in December.
The markets appear to have run ahead of themselves in pricing a slowdown in terms of both frequency and magnitude of rate hikes starting from December. Traders expect the rate hike cycle to peak around 4.8%, down from the terminal rate of 5% priced two weeks ago, according to the futures tied to the Fed funds rate. Bitcoin has gained 10% in two weeks, while the dollar index has dropped by over 2%.
However, inflation remains sticky, suggesting that the Fed has little room to turn dovish and halt rate hikes anytime soon, which is a negative sign for risk assets.
The data released on Friday showed that the Fed's preferred measure of inflation, the core PCE, rose 0.5% month-on-month in September, the same as in August, leaving the year-on-year increase at 5.1%. That's significantly higher than the annual inflation target of 2%. Further, employment costs continue to rise at the double the rate registered over the past 15 years.
Therefore, the Fed could continue to hike rates at a slower pace for longer, potentially lifting borrowing costs well above the terminal rate of 4.8% priced in by markets.
"The Fed will stress data dependence next week. They will get two more NFP & CPI prints before the Dec meeting; if they stay hot, another 75 bps is in the cards, if not, a deceleration to 50 bps is possible," strategists at Bank of America wrote in a weekly note sent to clients on Friday. "While the market badly wants a pivot, slower doesn't mean lower."
"The Fed isn't done hiking until the data says so. Core CPI is at cycle highs, U3 unemployment is at cycle lows. Corporates tell us their top challenge is hiring. China & US are decoupling. Capex is rising. Food & energy are increasingly scarce. Inflationary pressures seem broad-based & increasingly entrenched. Short-term survey inflation expectations have risen. The Fed's job is not done," strategists added.
Barclay's credit research team voiced a similar opinion in the weekly note, saying a potential bias for smaller rate hikes wouldn't mark a dovish pivot in the true sense of the word.
"The Fed needs to see inflation turning and labor market conditions deteriorating before turning meaningfully dovish. As such, we think it is likely to retain optionality for December, so we see limited further downside for the USD and could see the broad dollar rebound this week," Barcalys' credit research team said.
A dollar rebound will likely weigh over risk assets, including cryptocurrencies. Bitcoin tends to move in the opposite direction of the dollar.
Lee Hardman, currency analyst at MUFG Bank, said in Tuesday's client note, "If the Fed does slow the pace of hikes in December, it does not necessarily mean as well that the total amount of tightening delivered in the current tightening cycle will be less, although that will be the initial assumption."
"It could be that the Fed slows the pace of hikes but eventually keeps hiking for longer," Hardman added.
Here is what other banks expect:
"It is too early to turn soft for the Fed, and we look for a 75bp hike and hawkish communication. Fed to hike by another 150bp this year, then stop."
"While we may well get a “step down” in the pace of tightening from December onwards, it is clear that inflation is far from defeated, and the risks are that rate hikes could continue for longer."
We expect Fed Chair Powell to repeat that policy is data dependent and will be decided on a meeting-by-meeting basis, but also that it, at some point, likely would be appropriate to slow the pace of increases, thus keeping all options on the table for December, when the FOMC will release new economic and rate forecasts."