Wall Street Comments on the Fed's Decision: Does Waller Welcome Markets Replacing "Rate Hikes"?
- Core Viewpoint: The Fed kept rates unchanged at its July meeting. Chairman Waller tacitly approved the rise in long-term Treasury yields, effectively "outsourcing" part of the financial tightening to the bond market as a substitute for official rate hikes. However, this move may push up long-term interest rates, increase the risk of de-anchored inflation expectations, and raise the potential for future policy volatility.
- Key Elements:
- The Fed held the federal funds rate steady at 3.50%-3.75%, though three officials supported a 25-basis-point hike. The statement saw minimal changes and lacked clear forward guidance.
- Waller explicitly welcomed the market’s self-driven tightening of financial conditions, stating "the market has already done a lot," suggesting that maintaining higher long-end yields could reduce the need for proactive Fed rate hikes.
- Goldman Sachs extracted four dovish signals from Waller's comments: downplaying AI-related inflation pressures, attributing the rise in real interest rates to a strong economy, signaling that market rates can replace rate hikes, and emphasizing the use of credibility to lower inflation expectations.
- Barclays and Nomura noted that Waller’s remarks imply a higher threshold for rate hikes but a lower barrier for continued upward movement in long-end yields. The 30-year Treasury yield briefly surpassed 5.20%.
- Nomura warned that Waller’s dovish leanings and vague policy reaction function could undermine the Fed’s anti-inflation credibility, causing the 5-year forward breakeven inflation rate to jump, thereby planting the seeds of de-anchored inflation expectations.
Original author: Ye Zhen
Original source: Wall Street CN
The Federal Reserve kept interest rates unchanged at its July meeting. In a meeting lacking clear forward guidance, Fed Chair Warsh's tacit approval of rising long-term yields became the market focus, with institutions generally believing this signals that Wall Street's spontaneous tightening is replacing official rate hikes.
At the just-concluded FOMC meeting, the Fed decided to maintain the federal funds rate target range at 3.50%-3.75%. The meeting statement had minimal changes, but unusually, three regional Fed presidents (Hammack, Kashkari, and Logan) dissented, voting for a 25-basis-point rate hike.
Warsh's welcoming attitude towards the market's spontaneous tightening of financial conditions makes it clear that while the Fed has done little over the past 42 days, the market has done a lot. As a result, the U.S. Treasury yield curve steepened sharply. Short-term rates fell amidst rising energy prices, while long-term rates climbed significantly, with the 30-year Treasury yield briefly breaking above 5.20%.
Faced with the persistent rise in long-term Treasury yields, Warsh not only refrained from suppressing them but instead viewed financial conditions as having been actively tightened by the market. This implies that as long as long-term rates remain elevated, the necessity for the Fed to proactively hike rates will significantly decrease. Analysts at Goldman Sachs, Barclays, and Nomura believe the Fed is tacitly allowing the bond market to substitute for official rate hikes. However, this strategy may also push long-term yields higher and sow the seeds for risks of unanchored inflation expectations and increased future policy volatility.
A "Dovish" Pause Lacking Guidance
In a report, Goldman Sachs analyst David Mericle noted that heading into the meeting, market uncertainty over whether the Fed would hike was the greatest in three decades, yet the final outcome was somewhat anticlimactic. Goldman Sachs believes Warsh's comments at the press conference were generally dovish and intentionally avoided providing clear policy guidance to the market.
Despite the lack of direct guidance, Goldman Sachs extracted four core dovish signals from Warsh's statements.
First, Warsh intentionally downplayed price pressures related to AI, suggesting price increases in these areas might be independent of broader inflation trends. Second, when asked if the recent rise in real interest rates suggested the market believed the Fed should hike, he attributed it to the economy's strong performance. Third, he repeatedly hinted that rising market rates could substitute for policy rate hikes. Fourth, Warsh argued that enhancing the Fed's credibility in achieving its inflation target could lower inflation more effectively by reducing inflation expectations, compared to directly suppressing demand through rate hikes.
Goldman Sachs expects that weakening core inflation data over the coming months will keep the Fed on hold for the remainder of 2026. Currently, the bond market implies roughly a 60% probability of a rate hike at the September FOMC meeting.
Core Focus: Market-Driven Tightening Substituting for "Rate Hikes"
The signal that most captured Wall Street's attention in this decision was Warsh's attitude towards the recent rise in bond market yields. Both Barclays and Nomura emphasized in their reports that Warsh not only refrained from pushing back against the rise in long-term yields but actually welcomed it, strongly suggesting that rising market rates could substitute for substantive Fed rate hikes.
Barclays pointed out that analysis using the Fed's own FRBUS model shows a sufficient increase in the term premium can substitute for a higher federal funds rate. Warsh explicitly stated at the press conference that the recent rise in nominal and real yields is among the most significant moves in the past two decades. He attributed this to the economy's strong performance and commended market participants for "learning to play the game, not watch the referee," calling it a "welcome development."
Goldman Sachs also picked up on this detail. When asked why the Fed would pause given a strong economy, Warsh directly responded that market rates "haven't paused." He explicitly stated that while the Fed has done little over the past 42 days, the market has done a lot.
Nomura believes that Warsh's treatment of tightening financial conditions as a policy substitute represents a preference for an "unfiltered" market signal. This also implies that as long as long-term rates remain elevated, the urgency for the Fed to actively pull the trigger on rate hikes will be significantly reduced.
Rising Long-Term Yields and the Risk of Inflation Expectations
As the Fed partially "outsources" the task of tightening financial conditions to the bond market, Wall Street institutions are adjusting their investment strategies and remaining vigilant about the potential risk of unanchored inflation expectations.
Barclays believes that with increased uncertainty in the policy reaction function, the bar for a September rate hike is getting higher, but the bar for a continued rise in long-term yields has lowered. The institution notes that the 30-year Treasury yield breaking above 5% was not a flash in the pan, and current yield levels have not excessively priced in a rise in the neutral rate. Therefore, it maintains its investment recommendation of paying the 5-year forward Overnight Indexed Swap (5y5y SOFR) rate.
Nomura, however, issued a warning regarding the Fed's inflation credibility. Nomura points out that Warsh's persistent dovish lean and vague explanations of the policy reaction function could undermine the Fed's credibility in fighting inflation. This directly contributed to a jump in the 5-year forward breakeven inflation rate after the meeting.
Nomura warns that any slight sign of inflation stabilizing or the disinflation process stalling could trigger a more violent market reaction due to concerns over the Fed's credibility. This risk of long-term inflation expectations becoming unanchored could ultimately force the hawkish members within the FOMC to adopt a more forceful counter-response.
