Market Implicitly Enacts "Rate Hikes," Walsh Fully Committed to "Fighting Inflation"
- Key Takeaway: The sharp rise in U.S. Treasury yields has partially substituted for actual Fed rate hikes. Combined with Fed Chair Walsh's hawkish stance, the market is forming a consensus expectation for rate increases. However, Walsh deliberately preserves policy flexibility, leading to persistent divergence over the pace of tightening.
- Key Elements:
- Although the monthly decline in the June U.S. CPI provided a brief respite for the market, officials like Walsh have clearly stated the fight against inflation is not over. The market still prices in a 25 basis point rate hike in September or October.
- Since late February, the two-year Treasury yield has risen by approximately 75 basis points, reaching nearly 4.2%. This is significantly higher than the current policy rate range of 3.5% to 3.75%, effectively cooling the economy by raising borrowing costs.
- Traders broadly expect a rate hike before year-end is nearly a certainty. Persistent inflationary pressures—such as rising oil prices and AI-driven capital expenditure stimulating the economy—make it difficult for the market to quickly pivot dovish.
- Walsh's hawkish stance is clear, but he downplays providing explicit guidance on the timing of rate hikes to retain policy flexibility. Since taking office, he has consistently prioritized lowering inflation and emphasized maintaining the Fed's independence.
- Market divergence persists: Some institutions, like Bank of America, anticipate rate hikes in September, October, and December. Others, like BlackRock, believe market pricing is overly hawkish and maintain a cautious view on inflation trending downward in the second half of the year.
Original Author: Zhao Ying
Original Source: Wall Street News
The sharp rise in U.S. Treasury yields has, to some extent, already substituted for the effect of actual rate hikes, while the hawkish stance of Fed Chair Warsh has provided a clear anchor for this market pricing. An unusual tacit understanding is forming between the bond market and the Federal Reserve.
The U.S. Consumer Price Index (CPI) recorded its first monthly decline since 2020 in June, offering the market a brief sigh of relief and prompting rapid unwinding of bets on a Fed rate hike this month. But Warsh quickly made his stance clear on Capitol Hill, stating that the June CPI data does not mean the anti-inflation mission is complete. Kansas City Fed President Jeff Schmid, Dallas Fed President Lorie Logan, and Cleveland Fed President Beth Hammack also issued similar signals in succession.
Currently, traders' expectations for a July rate hike have largely faded, but they still widely bet the Fed will raise the benchmark interest rate by 25 basis points in September or October, with a rate hike before year-end seen as virtually certain. Meanwhile, since the end of February, the two-year U.S. Treasury yield has risen by about 75 basis points cumulatively to nearly 4.2%, well above the Fed's current policy rate range of 3.5% to 3.75%. The rise in Treasury yields has effectively put the brakes on the economy by pushing up mortgage and other borrowing costs.
Inflationary Pressures Persist, Rate Hike Expectations Loom
Despite the brief respite offered by the June CPI data, market concerns about the inflation outlook have not dissipated. Oil prices have risen again following the breakdown of the U.S.-Iran ceasefire agreement; massive capital expenditure in the artificial intelligence field continues to inject stimulus into the economy, even as some tech stocks have sparked bubble concerns. With inflation having consistently exceeded the Fed's 2% annual target over the past five years, this stubborn trend makes it hard for the market to pivot decisively.
Ed Al-Hussainy, portfolio manager at Columbia Threadneedle, said: "If you do nothing, are you confident inflation will fall back to 2% or 2.5%? The answer is no. The Fed should feel more confident in raising rates without worrying too much about downside risks." He currently holds a position where long-dated bonds outperform short-dated bonds, a strategy that would benefit from a more hawkish Fed policy path.
Economists at Bank of America expect the Fed to raise rates at its three meetings in September, October, and December, respectively. After the June CPI data was released, the bank noted in a client report that inflation remains well above target, stating that "several more such data points would be needed before we reconsider our current judgment."
Market Does the Heavy Lifting, Warsh Can Wait and See
The spontaneous pricing of the bond market is objectively sharing the policy burden of the Federal Reserve. Jeffrey Sherman, deputy chief investment officer at DoubleLine, pointed out that based on the forward pricing of the federal funds rate, the bond market has often anticipated Fed actions in the past. The most significant change now is that the market is no longer consistently betting on rate cuts, as it did over the past three years, but is instead starting to reflect the possibility of rate hikes sometime in the next year.
Sherman noted that this starkly contrasts with previous policy cycles: "The market heard Powell declare the end of rate hikes and began to expect cuts, but the cuts never really materialized." Now, "the market seems to be saying: maybe the Fed will raise rates at some point in the next 12 months."
In his view, this means Warsh may not need to act immediately right now. "What you're seeing now is that the market has effectively done the Fed's work for it—the rate curve is upward sloping, with the policy rate below all other rates on the curve. So, Chair Warsh perhaps doesn't need to do anything for now and can wait and see how things evolve," Sherman concluded: "The bond market is doing its job; it's sniffing the data."
Warsh's Hawkish Stance Clear, But Room for Flexibility Reserved
Warsh took over as Fed Chair two months ago and has prioritized lowering inflation since taking office. At his first post-meeting press conference last month, he repeatedly emphasized the need to control inflation; during his testimony on Capitol Hill last week, he reiterated that the June CPI data does not mean the mission is complete.
Notably, Warsh did not give a clear signal on the timing of rate hikes and tends to downplay the Fed's forward guidance on the rate outlook, arguing that overly explicit guidance could trap policymakers in a corner and limit their flexibility. Fed officials will enter a standard quiet period ahead of the two-day meeting starting July 28, leaving the market short of fresh policy signals during this time.
The Fed has remained on hold since its last rate cut in December. At that time, the job market rebounded from its February trough, coupled with a new wave of inflationary shocks from the Trump administration's military actions against Iran, dashing previous widespread market expectations for the Fed to resume rate cuts. Warsh has made clear that he will safeguard the Fed's political independence and will not yield to Trump's pressure for lower rates.
Market Divergence Remains, Caution Still the Keynote
Despite rate hike expectations dominating the market, some institutions hold a more cautious view on the pace of actual Fed action. Chi Chen, co-manager of BlackRock's $18 billion Total Return Fund, said: "The market's pricing of the Fed's policy path is more hawkish than we expected, assuming our judgment that inflation will decline and growth will slow in the second half is correct. The Fed may maintain its hawkish stance, waiting for the data to eventually soften." Her team currently prefers allocating to medium- and short-term bonds, believing that after the post-Iran war selloff, "valuations are clearly much more attractive than before."
Sherman also expressed reservations about the threshold for a September rate hike, suggesting it would take "a lot of data" to force the Fed into such a decision, especially with elections approaching and political pressures persisting.
Al-Hussainy stated bluntly: "This is not the time to stick your neck out." With the policy path still unclear, avoiding heavy bets on sensitive Fed policy positioning may be the safest course of action for now.
