Market Takes on 'Rate Hike', Waller Fully 'Fights Inflation'
Waller's hawkish stance provides an anchor for the market, with a rate hike in September becoming a consensus.
Written by: Zhao Ying, Wall Street Watch
The significant rise in U.S. Treasury yields has, to some extent, replaced the actual effect of rate hikes, while Federal Reserve Chairman Waller's hawkish position provides a clear anchor for this market pricing. A rare 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, giving the market a brief sigh of relief, and positions betting on a rate hike by the Fed this month were quickly closed. However, Waller promptly stated on Capitol Hill that the June CPI data does not mean the fight against inflation is over. Kansas City Fed President Jeff Schmid, Dallas Fed President Lorie Logan, and Cleveland Fed President Beth Hammack also issued similar signals.
Currently, traders' expectations for a rate hike in July have largely dissipated, but there is still a general bet that the Fed will raise the benchmark rate by 25 basis points in September or October, and a rate hike before the end of the year is almost seen as a certainty. Meanwhile, since the end of February, the two-year U.S. Treasury yield has risen by about 75 basis points to nearly 4.2%, far exceeding the Fed's current policy rate range of 3.5% to 3.75%. The rise in Treasury yields has effectively acted as a brake on the economy by pushing up mortgage and other loan costs.
Inflation Pressures Persist, Rate Hike Expectations Loom
Despite the brief respite from the June CPI data, concerns about the inflation outlook have not dissipated. After the collapse of the U.S.-Iran ceasefire agreement, oil prices have risen again; large-scale capital expenditures in the field of artificial intelligence continue to inject stimulus into the economy, even as some tech stocks have raised bubble concerns. Inflation has remained above the Fed's 2% annual target for the past five years, making it difficult for the market to easily shift direction.
Columbia Threadneedle portfolio manager Ed Al-Hussainy stated, "If nothing is done, are you confident that inflation will fall back to 2% or 2.5%? The answer is no. The Fed should feel more confident in raising rates without overly worrying about downside risks." He currently holds a position favoring 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 its meetings in September, October, and December. After the June CPI data was released, the bank noted in a client report that inflation remains well above target, "We need to see a few more similar data points before reconsidering our current judgment."
The Market Has 'Taken Over', Waller Can Watch and Wait
The spontaneous pricing in the bond market is objectively relieving the policy pressure on the Fed. DoubleLine Deputy Chief Investment Officer Jeffrey Sherman pointed out that, based on the forward pricing of the federal funds rate, the bond market has often led the Fed's actions in the past, and the most important change now is that the market is no longer continuously 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 noted that this contrasts sharply with previous policy cycles: "The market heard Powell announce the end of rate hikes and began to expect rate cuts, but the cuts never actually 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 that Waller may not need to take immediate action. "What you see now is that the market has actually done the work for the Fed—the yield curve is sloping upward, and the policy rate is below all other rates on the curve. So, Chairman Waller may not need to take any action for the time being and can watch and wait." Sherman summarized, "The bond market is fulfilling its role; it is sniffing out the data."
Waller's Hawkish Stance is Clear, but He Intentionally Leaves Room for Flexibility
Waller took over as Fed Chairman two months ago and has consistently prioritized lowering inflation as his primary task. During his first press conference after presiding over a meeting last month, he repeatedly emphasized the necessity of controlling inflation; last week, while testifying in Congress, he reiterated that the June CPI data does not signify mission accomplished.
Notably, Waller has not given clear signals regarding the timing of rate hikes and tends to downplay the Fed's forward guidance on interest rate prospects, reasoning that overly explicit guidance could trap decision-makers in a passive position, making it difficult to adjust flexibly. Fed officials will enter a routine quiet period ahead of their 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 job market rebounded from a low in February, coupled with new inflationary shocks from the Trump administration's military actions against Iran, leading to a general expectation in the market that the Fed would restart rate cuts being dashed. Waller has clearly stated that he will maintain the Fed's political independence and will not yield to Trump's pressure for rate cuts.
Market Discrepancies 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 BlackRock's $18 billion Total Return Fund, stated, "The market's pricing of the Fed's policy path is more hawkish than we expected, provided that our judgment on inflation declining and growth slowing in the second half of the year is correct. The Fed may continue to maintain a hawkish stance, waiting for data to ultimately moderate." 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 "large amount of data" is needed to compel the Fed to make this decision, especially in the context of approaching elections and ongoing political pressure.
Al-Hussainy bluntly stated, "Now is not the time to take risks." In the face of unclear policy paths, avoiding heavy bets on sensitive positions related to the Fed may be the most prudent choice at this time.
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