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“Don’t fight the Fed” has been one of the most voiced mantras on Wall Street.
Yet, that’s precisely what investors have done in recent weeks. Despite the Federal Reserve’s repeated warnings of continued liquidity tightening ahead, there has been a risk revival in almost all corners of the financial market, including retail-dominated meme stocks and dog-themed cryptocurrencies.
That has the crypto options trading firm QCP Capital now worried about a Fed pushback.
“What will raise the FOMC’s [Federal Open Market Committee] ire is how quickly financial conditions have loosened in this period which, together with the rally of meme stocks and crypto, risks severely derailing their inflation fight,” QCP Capital’s insights team said in a note published Thursday.
“While we expect the Feb. 1 FOMC meeting to push back strongly against this pricing, we believe the March 22 FOMC will be the moment of truth, when updated rate forecasts will be released. Should there be no adjustment to the median 2023 dot plot, then we expect markets will be in for a rude shock,” QCP added. The Singapore-based options trading giant is one of the few firms that warned of a Fed-induced market swoon before it began in late 2021.
The central bank raised rates from zero to 4.25% last year and plans to lift them further this year to levels above 5% and keep them elevated for some time, as Fed President Jerome Powell signaled in December and several Federal Open Market Committee (FOMC) members have suggested since then.
The interest rate “dot plot” published by the FOMC in December showed the median rate at the end of 2023 at 5.1%, a significant upward revision from 4.6% at the September 2022 projection.
The Fed expects financial conditions to tighten when fighting inflation with liquidity-sucking measures such as interest rate hikes. Financial conditions tighten when bond yields rise, credit spreads widen, stock prices fall and the U.S. dollar strengthens.
However, the opposite has happened, complicating the Fed’s effort to control the general price level in the economy by tightening credit standards and weakening demand-pull inflation.
The dollar index, which tracks the greenback’s value against major currencies, has dropped by 11% since late September. The S&P 500, Wall Street’s benchmark equity index, has bounced 12% in three months, while the 10-year Treasury yield has fallen by nearly 100 basis points to 3.38%. Other risk assets such as bitcoin, the leading cryptocurrency by market value, have gained over 25% this month, according to CoinDesk data. If that’s not enough, shiba inu, the self-proclaimed dogecoin killer, has rallied 35% this month and meme stock Bed Bath & Beyond has jumped 56%.
Bloomberg’s financial conditions index has turned positive for the first time since April 2022, when the fed funds rate stood between 0.25% and 0.5%. In other words, markets have undone nearly 400 basis points worth of Fed tightening.
Financial conditions in the U.S., contradicting the Fed’s hawkish stance. (Bloomberg, Valerie Tytel) (Bloomberg, Valerie Tytel)
The premature easing could be attributed to hopes that falling inflation expectations and signs of economic slowdown would force the Fed to cut rates later this year has powered.
“The excesses of the prior inflationary regime are starting to reemerge. The meme stock basket is now up 25%, while altcoins like solana have doubled in value in less than a month. Total [non-fungible token] market cap has quietly crept up close to last year’s high levels of 9 million-9.5 million ETH, worth $13.3 billion at today’s prices,” QCP said, while noting that the rebound may not be long lasting.
“While we wrote in our first market update of the year that NFT prices were a harbinger for a broader rally to come, we do not expect those to be sustained while the Fed is still on a warpath against inflation, and all the assets that feed it,” QCP added.
Bitcoin changed hands at $20,700 at press time. While the Fed is likely to stay hawkish, the U.S. Treasury Department’s decision to run down its cash holdings to avoid a government shutdown may damp the Fed’s tightening to some extent in coming weeks.
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