Market "Rate Hikes" on Autopilot, Waller Goes "All-In Against Inflation"

Original Author: Zhao Ying

Original Source: Wall Street News

The sharp rise in U.S. Treasury yields has, to a certain extent, already substituted for the effect of actual interest rate hikes, while Fed Chair Warsh's hawkish stance provides 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 a brief sigh of relief in the market and prompting a rapid unwinding of positions betting on a Fed rate hike this month. However, Warsh immediately made his position clear on Capitol Hill, stating that the June CPI data does not mean the task of fighting inflation 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, trader expectations for a rate hike in July have largely dissipated, but widespread bets remain that the Fed will raise the benchmark interest rate by 25 basis points in September or October, with a rate hike before the end of the year being almost considered a certainty. Meanwhile, since the end of February, the two-year U.S. Treasury yield has accumulated an increase of approximately 75 basis points to nearly 4.2%, far exceeding the Fed's current policy rate range of 3.5% to 3.75%. This rise in Treasury yields has effectively acted as a brake on the economy by pushing up mortgage and other borrowing costs.

Inflationary Pressures Persist, Rate Hike Expectations Loom Large

Despite the temporary respite offered by the June CPI data, market concerns about the inflation outlook have not dissipated. Oil prices have risen again following the collapse of the U.S.-Iran ceasefire agreement. Massive capital expenditures in the field of artificial intelligence continue to inject stimulus into the economy, even as concerns about a bubble in some tech stocks emerge. With inflation having consistently remained above the Fed's 2% annual target over the past five years, this stubborn trend makes it difficult for the market to easily signal a turning point.

Ed Al-Hussainy, a portfolio manager at Columbia Threadneedle, stated: "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 about raising rates without having to worry too much about downside risks." He currently holds a position favoring long-term bonds over short-term bonds, a strategy that would benefit from a more hawkish policy path from the Fed.

Economists at Bank of America expect the Fed to raise interest rates at its three meetings in September, October, and December, respectively. Following the release of the June CPI data, the bank stated in a client note that inflation remains well above target and "we would need to see several more data points like this before reconsidering our current stance."

The Market Has Done the Heavy Lifting; Warsh Can Wait and See

The self-directed pricing in the bond market is objectively shouldering some of the Fed's policy pressure. Jeffrey Sherman, Deputy Chief Investment Officer at DoubleLine, pointed out that based on forward pricing of the federal funds rate, the bond market has often led Fed actions in the past. The most significant change now, he argues, is that the market is no longer persistently betting on rate cuts as it did over the past three years; instead, it is starting to reflect the possibility of rate hikes within the coming year.

Sherman noted this stands in stark contrast to previous policy cycles: "The market heard Powell declare the end of rate hikes and started expecting cuts, but those cuts never really materialized." Now, "the market seems to be saying: Maybe the Fed will hike rates at some point in the next 12 months."

In his view, this means Warsh may not necessarily need to act immediately. "What you're seeing is that the market has actually done the Fed's job for it – the yield curve has steepened, and the policy rate sits below all other rates on the curve. So, Chairman Warsh might be able to take no action for the time being and simply wait and see," Sherman concluded: "The bond market is doing its job; it's sniffing the data."

Warsh's Hawkish Stance is Clear, But Flexibility is Deliberately Preserved

Warsh assumed the role of Fed Chair two months ago and has made curbing inflation his top priority since taking office. During his first post-meeting press conference last month, he repeatedly emphasized the need to control inflation. Testifying before Congress last week, he reiterated that the June CPI data does not mean the mission is accomplished.

Notably, Warsh has refrained from giving clear signals regarding the timing of rate hikes and tends to downplay the Fed's forward guidance on the interest rate outlook, arguing that overly explicit guidance could trap policymakers and hinder their ability to adjust flexibly. Fed officials will enter their standard quiet period before the two-day meeting starting July 28th this week, during which the market will lack new policy signals.

The Fed has held rates steady since its last rate cut in December. At that time, the labor market rebounded from its February trough, and the Trump administration's military actions against Iran brought a new wave of inflationary shocks, dashing previous market expectations for the Fed to restart rate cuts. Warsh has clearly stated his intention to uphold the Fed's political independence and will not yield to Trump's pressure for rate cuts.

Market Divergence Remains, Caution is Still the Key Theme

Despite rate hike expectations dominating the market, some institutions adopt a more cautious assessment of the pace of the Fed's actual actions. Chi Chen, co-manager of BlackRock's $18 billion Total Return Fund, stated: "The market's pricing of the Fed's policy path is more hawkish than we expected, based on our assumption that inflation will ease and growth will slow in the second half of the year. The Fed might maintain its hawkish stance, waiting for the data to eventually moderate." Her team currently prefers allocating to medium and short-term bonds, believing that after the selloff following the Iranian conflict, "valuations are clearly more attractive than before."

Sherman also expressed reservations about the threshold for a September rate hike, arguing that it would take "a lot of data" to force the Fed into such a decision, especially amid the approaching elections and persistent political pressures.

Al-Hussainy stated bluntly: "Now is not the time to stick your neck out." With the policy path still unclear, avoiding heavy bets on rate-sensitive positions might be the safest course of action for now.