Financial markets started the new year on the same note as the previous year ended – higher stocks, lower dollar. The extent of the advance in the stock market, or the decline in the dollar, led many market participants to wonder if the Fed’s monetary policy did not lead to financial bubbles?
After all, a survey shows that over 25% of the market participants still believe that Bitcoin will double from the current levels. Or, 18% believe that the price of Tesla will double over the next twelve months. That is, in the context of Bitcoin already rising from $10,000 to $40,000 in the last months and Tesla already being up over 650% in 2020.
Will the Dollar Weakness Stop?
To many, the weakness in the dollar is responsible for such extreme price action. If we are to see a change in the trend, as suggested by the 56% of the market participants that expect a higher dollar against Bitcoin for the next twelve months, then the risk may come from Wednesday Fed’s decision.
On Wednesday, the Fed is expected to keep the monetary policy unchanged – the federal funds rate at the lower boundary and the QE program running at $120 billion/month. However, this week, the focus will shift from the FOMC Statement to the Fed’s press conference.
More precisely, it will be more important what the Fed thinks about the future economic outlook. In the face of the rapid pace of vaccinations (i.e., the United States already vaccinated 6% of its population), the risk is that the Fed will deliver a slightly hawkish outlook for the future economic recovery. If that is the case, the dollar may turn in the expectation of the future tapering of the quantitative easing program.
Last week the ECB delivered a slightly hawkish statement too. It said that it may or may not use the full envelope of the PEPP program, despite the fact that many European countries face the worse of the pandemic right now.
As such, one should not discount a hawkish Fed too. If that happens, the USD will make a U-turn because the reflation trade that went on for months now seems to be extremely stretched.
As we saw in 2020, the dollar’s direction matters for the equity markets and other markets too. For stocks to remain close to all-time highs, the correlation with the dollar must break.
Will we see such a divergence on Wednesday? Or will the reflation trade continue after the Fed’s first meeting of the year?