This is the "most uncertain" one in years. Will the Fed deliver a "shock" tonight?

Original Author: Zhao Ying

Original Source: Wall Street CN

Tonight's Fed decision is widely expected to be a "hold," but what the market truly fears is not the base case, but a rare surprise rate hike, or a pause accompanied by a hawkish enough statement.

At 2:00 AM Beijing time on July 30th, the Federal Reserve will announce its latest interest rate decision. This meeting has no dot plot or economic forecast updates, and the federal funds rate target range is expected to remain at 3.50%-3.75%. According to a Reuters poll, all 104 respondents predicted rates would remain unchanged. However, money markets still price in roughly a 32% probability of a rate hike this week and have priced in about 42 basis points of tightening for the year, making tonight the most "uncertain" meeting in recent years.

The uncertainty stems from a tug-of-war between two forces. June's CPI came in broadly below expectations, non-farm payrolls were weaker than forecast, and oil prices fell ahead of the meeting, all providing room for the Fed to wait further. However, inflation remains above target, the situation in the Middle East and oil prices are volatile, several Fed officials have recently sounded hawkish, and coupled with Chairman Warsh not yet having a clear policy track record, the market cannot fully rule out the risk of a rate hike.

Jonathan Pingle, Chief US Economist at UBS, stated, His level of uncertainty about the upcoming Fed decision is the highest in 20 years — the last time he felt similarly was when Bernanke had just taken over as Fed Chair. "Warsh will steer policy direction in the coming meetings, and we know almost nothing about how he views monetary policy."

For investors, the risks are concentrated on the short end of the yield curve, and the immediate reaction of the US dollar and US stocks. According to JPMorgan's Market Intel calculations, if the Fed unexpectedly hikes by 25 basis points, the S&P 500 index could fall by 1.5%-2%; a 50 basis point hike could lead to a decline of 2%-4%. Even if rates are held steady, a hawkish statement and press conference could limit the rebound in risk assets.

Market Consensus is a Pause, But Pricing is Not Calm

From a traditional forecasting perspective, this decision seems like a foregone conclusion. According to the Reuters poll, all 104 economists expect the Fed to hold rates steady. Among them, 78 expect no rate change for the rest of the year, while only 6 predict a rate cut.

However, the same survey showed that 66% of respondents believe the likelihood of a rate hike this year is "high," a significant shift from the "low" mainstream judgment in June. Market pricing also indicates investors are paying for tail risk of a hike. Traders not only price in roughly a 30% chance of a hike this week but also fully price in a 25 basis point hike by September and nearly a 50 basis point hike by March of next year.

Goldman Sachs believes this pricing makes the outcome of this meeting "unusually uncertain." If the Fed hikes, it would be a historically rare unexpected move; if it doesn't, the market will quickly reassess the previously priced-in risk of a hike. Ian Lyngen of BMO Capital Markets noted that since 2015, traders' average error in predicting the final rate decision the day before a Fed meeting has been only 2.4 basis points. This time, the market is more prone to more violent immediate reactions than usual.

Data Supports Waiting, But Inflation Risks Remain

The main arguments supporting a Fed pause come from the latest data. June's CPI came in below expectations, weakening the rate hike bets that had been spurred by Waller's previous hawkish comments. Waller had stated that if June's core CPI came in hot, a near-term rate hike should be considered; if the data was cool, he would need to see more similar readings before taking it as a clear signal.

The labor market also gives the Fed more time to observe. June's non-farm payrolls were weaker than expected, with prior figures revised down. The net revision over the past two months was a decrease of 74,000 jobs, compared to a previous increase of 93,000. While the unemployment rate edged down, the data suggests this might be primarily due to an overall decline in labor force participation.

Oil prices are also a key variable. The conflict between the US and Iran escalated after the last meeting, with a related memorandum of understanding being violated and both sides resuming strikes. However, over the weekend before the meeting, the strikes paused, geopolitical risk premiums decreased, and oil prices subsequently fell, which helps ease inflation expectations. Fed officials have previously cautioned against reacting too quickly to what might be temporary supply shocks.

The problem is that underlying inflation remains well above target. Morgan Stanley points out that upside risks include persistently high oil prices, a more hawkish Fed reaction function, and AI-driven investment pushing up the neutral rate. Goldman Sachs also believes that the combined impact of tariffs, war, and AI statistical errors on monthly inflation may weaken in the future, but uncertainty remains high. Once the improvement in inflation stalls, discussions about rate hikes within the Fed could reignite.

Communication in the Warsh Era is a Risk in Itself

The last FOMC meeting chaired by Warsh was also his first. At that time, the statement was significantly shortened, forward guidance language was removed, and the committee's commitment to bringing inflation back to the 2% target was strengthened. This means that even subtle wording changes this time will be magnified and interpreted by the market.

Morgan Stanley expects the statement this time will likely remain largely unchanged, including reaffirming the "ample reserves" policy, describing economic activity as expanding at a "solid pace" amid high uncertainty, with the unemployment rate "little changed" and inflation remaining "elevated." Since there are no Summary of Economic Projections this month, policymakers don't need to reset market expectations via the dot plot.

The press conference may be more important. Warsh is expected to be asked about the impact of the Middle East conflict on inflation, the newly announced Chairman's working group, and whether the latest data will advance the timeline for policy action. Goldman Sachs expects Warsh will not give clear policy signals but may emphasize that all options remain open and future decisions depend on the data.

Credit Agricole believes the Fed is entering a new phase of more limited forward guidance, which will make more meetings truly "live." The bank expects the Fed to remain on hold this time and believes the data since the last meeting has at least bought time for another pause. Regarding the five new working groups established by Warsh, Credit Agricole does not expect major updates in the near term, with recommendations likely not finalized until close to year-end. This also means that balance sheet policy is unlikely to change for now.

Divergence Widens: A Pause Could Also Come with Dissent, Watch for Dissenting Votes

Divisions within the Fed are at the core of the uncertainty for this meeting. In the June projections, 9 of the 18 participants who submitted forecasts expected at least one rate hike this year. Subsequent comments from several officials have indicated a willingness to consider further tightening if the disinflation process stalls.

Waller and Cook have both indicated they might consider tightening policy if the disinflation process stalls. 2026 voters Logan and Hammack have made more hawkish speeches. Logan argued for a moderately higher policy rate to better balance the outlook and risks, and believes a certain degree of restrictive policy is still needed to help bring inflation back to target. Hammack directly stated that the Fed might need to consider a rate hike.

Therefore, even if rates are held steady, dissenting votes are possible. Based solely on recent commentary, if the Fed chooses to pause, there could be 2 to 4 dissenting votes favoring a rate hike. Goldman Sachs expects the statement might acknowledge the upside risks to inflation from geopolitical conflicts, and that at least one member might vote for a rate hike.

Mark Cabana, an analyst at Bank of America, expects the Fed to hold rates steady on Wednesday but might attract dissenting votes from regional Fed presidents like Lorie Logan and Beth Hammack. He also noted that as long as the market doesn't rule out the risk of a rate hike, strategists won't either.

A Few Institutions Bet on a 'Shock' Rate Hike

Although the mainstream view remains a pause, some institutions are explicitly betting on a surprise hike. Citadel Securities stands out as a significant outlier, with its Head of Macro Strategy, Frank Flight, changing the base case this week to a 25 basis point hike. He believes this would strengthen Warsh's credibility in fighting inflation and "definitively end the era of forward guidance."

Robert Tipp, PGIM's Global Head of Bonds and Chief Investment Strategist, also stated that the market might be underestimating the probability of action on Wednesday. He believes, Warsh has essentially set the stage for a rate hike. Delaying the decision now could increase the probability of a 50 basis point hike in September.

Lou Crandall, Chief Economist at Wrightson ICAP, stated that the Fed has no strong reason not to hike. Bond market veteran Harley Bassman even argued that the Fed should hike by 50 basis points at once to strengthen its anti-inflation credibility.

However, Goldman Sachs still believes that most voting members are unlikely to push for a rate hike this week after the soft June inflation data. The bank also pointed out that the Fed has historically avoided surprising markets with rate hikes at meetings, especially those without Summary of Economic Projections, as officials may be more concerned about markets overinterpreting their intentions.

Asset Reaction: A Rate Hike is the Biggest Shock; a Hawkish Pause Isn't Easy Either

JPMorgan's Market Intel lists a "hawkish pause" as the base case, with a 50% probability. In this scenario, the S&P 500 index could rise by 0.25% or fall by 0.50%. The logic is that the Fed would pause due to lingering resilience in the labor market and growth, but continue to emphasize vigilance on inflation.

In the event of a surprise 25 basis point hike, JPMorgan expects the S&P 500 to fall 1.5%-2%, with the Nasdaq 100 potentially falling more. A 50 basis point hike could see the S&P 500 decline 2%-4%. In a "dovish pause" scenario—holding rates steady with accommodative communication—the S&P 500 could rise 0.50%-1%. In the options market, options expiring on July 29th priced in about 0.8% volatility for the S&P 500, lower than the roughly 1.1% pricing seen during recent CPI events.

In FX markets, the Goldman Sachs FX team believes that if the Fed pauses, the US dollar could weaken tactically, but this weakness is likely to be short-lived as long as energy prices remain high. In the medium term, if the Fed keeps rates unchanged for the rest of the year, as the bank's economists expect, it would put modest but manageable pressure on the USD against G10 currencies.

The focus in the rates market is on the front end. The Goldman Sachs rates desk believes the market might misinterpret a "lack of forward guidance" as intentional ambiguity. The desk leans towards the view that if the Fed Board of Governors does not support a rate hike, the hawkish voters do not have enough votes to push for action this week. However, if paused in July, Warsh could still deliver a hawkish pause and lay the groundwork for a September hike.

In commodities, the Goldman Sachs crude oil desk states that the risk premium in oil is rapidly fading, following a de facto ceasefire between the US and Iran over the weekend and progress in talks to reopen the Strait of Hormuz. However, upside risks haven't disappeared yet. If attacks on Saudi oil facilities or production continue, oil prices could move higher. Gold has been trading in a roughly $250 range over the past two months. The desk maintains a long-term bullish view but prefers tactical trading around news events.

This means that tonight's key is not just whether rates change, but how Warsh explains the "no change" or "change." Against the backdrop where the market has already paid for the risk of a rate hike, and economists overwhelmingly predict a pause, whichever path the Fed chooses could bring a significant shock to the market.