Walsh's hawkish stance provides an anchor for the market, and a rate hike in September has become almost a consensus.

Written by: Zhao Ying, Wall Street Insight

The significant rise in U.S. Treasury yields has, to some extent, replaced the actual effects of rate hikes, while Fed Chairman Walsh's hawkish position has provided a clear anchor for market pricing. A rare tacit understanding is forming between the bond market and the Federal Reserve.

The U.S. Consumer Price Index (CPI) in June recorded its first monthly decline since 2020, giving the market a brief sigh of relief and leading to rapid unwinding of positions betting on a Fed rate hike this month. However, Walsh promptly stated on Capitol Hill that the June CPI data does not mean the anti-inflation mission has been accomplished. Kansas City Fed President Jeff Schmid, Dallas Fed President Lorie Logan, and Cleveland Fed President Beth Hammack have also issued similar signals.

Currently, traders' expectations for a rate hike in July have largely faded, but there is still a widespread bet that the Fed will raise the benchmark rate by 25 basis points in September or October, and a hike before the end of the year is almost seen as a done deal. Meanwhile, since the end of February, the two-year U.S. Treasury yield has risen about 75 basis points to nearly 4.2%, well above the Fed's current policy interest rate range of 3.5% to 3.75%. The rise in Treasury yields has effectively acted to put the brakes on the economy by pushing up mortgage and other loan costs.

Inflation pressure remains, rate hike expectations linger

Despite the brief respite from the June CPI data, concerns about the inflation outlook have not dissipated. After the U.S.-Iran ceasefire agreement broke down, oil prices rose again; large-scale capital expenditures in the field of artificial intelligence continue to inject stimulus into the economy, even as there are some concerns about bubbles in certain tech stocks. Inflation has consistently remained above the Fed's 2% annual target over the past five years, making it difficult for the market to easily pivot.

Columbia Threadneedle portfolio manager Ed Al-Hussainy stated, "If you do nothing, do you have confidence that inflation will fall to 2% or 2.5%? The answer is no. The Fed should feel more confident in raising rates without being overly concerned about downside risks." He currently holds positions in long-term bonds over short-term bonds, a strategy that will benefit from a more hawkish policy path from the Fed.

Bank of America economists expect the Fed to raise rates at their meetings in September, October, and December. After the June CPI data was released, the bank noted in a client report that inflation remains far above the target, "we need to see a few more similar data points before reevaluating our current judgment."

The market has "done the work," Walsh can observe

The spontaneous pricing in the bond market is objectively sharing the policy pressure faced by the Fed. DoubleLine Deputy Chief Investment Officer Jeffrey Sherman pointed out that, based on the forward pricing of federal funds rates, the bond market has often led Fed actions, and the most important change now is that the market is no longer continually betting on rate cuts as it did in the past three years, but is beginning to reflect the possibility of rate hikes in the coming year.

Sherman stated, this sharply contrasts with previous policy cycles: "The market heard Powell announce the end of rate hikes and began to anticipate rate cuts, but cuts did not actually materialize." Now, "the market seems to be saying: perhaps the Fed will raise rates at some point in the next 12 months."

In his view, this means Walsh may not necessarily need to take immediate action. "What you see now is that the market has already done the Fed's work—the yield curve has a positive slope, and the policy rate is below all other rates on the curve. Therefore, Chairman Walsh may not need to take any action for the time being and can observe changes." Sherman summarized: "The bond market is fulfilling its duty; it is sniffing out data."

Walsh's hawkish position is clear, but he deliberately allows for flexibility

Walsh took over as Fed Chairman two months ago, and since then, has always prioritized lowering inflation as a key task. In last month's first press conference after hosting a meeting, he repeatedly emphasized the necessity of controlling inflation; last week during congressional testimony, he reiterated that June's CPI data does not imply mission accomplished.

It is noteworthy that Walsh has not given a clear signal regarding the timing of rate hikes and tends to downplay the Fed's forward guidance on interest rates, arguing that overly explicit guidance may put decision-makers in a passive position that is difficult to adjust flexibly. Fed officials will enter a routine blackout period ahead of the two-day meeting starting July 28, during which the market will lack new policy signals.

Since the last rate cut in December of last year, the Fed has remained on hold. At that time, the labor market rebounded from February's low, combined with new inflationary shocks brought about by the Trump administration's military actions against Iran, leading to a widespread expectation in the market that the Fed would resume rate cuts being dashed. Walsh has clearly stated that he will uphold the political independence of the Fed and will not yield to Trump's pressure for rate cuts.

Market divergences remain, caution is still the main tone

Although rate hike expectations dominate the market, some institutions hold a more cautious judgment on the pace of the Fed's actual actions. Chi Chen, co-manager of the $18 billion Total Return Fund at BlackRock, stated, "The market's pricing of the Fed's policy path is more hawkish than we anticipated, provided that we are correct in our judgment of declining inflation and slowing growth in the second half of the year. The Fed may continue to maintain a hawkish stance, waiting for data to ultimately soften." Her team currently leans towards allocating mid-term and short-term bonds, believing that after the sell-off following the Iran war, "valuations are clearly more attractive than before."

Sherman also holds a reserved attitude towards the threshold for a rate hike in September, believing that "a lot of data" is needed to compel the Fed to make that decision, especially against the backdrop of approaching elections and ongoing political pressures.

Al-Hussainy bluntly stated, "Now is not the time to take risks." In the face of an unclear policy path, avoiding heavy bets on sensitive positions regarding the Fed may be the most prudent choice at this time.