Market acts as a proxy for “rate hikes,” while Worsh fully works to “fight inflation”

By Zhao Ying, Wall Street Insights

The sharp rise in U.S. Treasury yields has, to a certain extent, replaced the effect of actual rate hikes, while Fed Chair Wossh’s hawkish stance has provided a clear anchor for market pricing. A rare tacit understanding is taking shape between the bond market and the Federal Reserve.

The U.S. Consumer Price Index (CPI) in June recorded its first month-over-month decline since 2020, giving the market a brief sigh of relief as traders quickly closed positions that had bet on a rate hike this month. But Wossh immediately made it clear on Capitol Hill that the June CPI data does not mean the anti-inflation mission has been completed. Kansas City Fed Chair Jeff Schmid, Dallas Fed Chair Lorie Logan, and Cleveland Fed Chair Beth Hammack also sent similar signals in succession.

At present, expectations for a July rate hike have largely faded among traders, but the view remains widespread that the Fed will raise the benchmark interest rate by 25 basis points in September or October, and that rate hikes before the end of the year are almost a foregone conclusion. Meanwhile, since the end of February, the yield on two-year U.S. Treasuries has risen cumulatively by about 75 basis points to nearly 4.2%, far above the Fed’s current policy-rate range of 3.5% to 3.75%. The rise in U.S. government bond yields has effectively played the role of a brake on the economy by pushing up mortgage and other borrowing costs.

Inflation pressure has not eased, and rate-hike expectations remain high

Although the June CPI data brought a temporary pause for breath, market concerns about the inflation outlook have not disappeared. After the collapse of the U.S.-Iran ceasefire agreement, oil prices rose again; large-scale capital expenditures in the artificial intelligence sector have continued to inject stimulus into the economy, even as some technology stocks have started to raise worries about a bubble. Inflation has remained above the Fed’s 2% annual target throughout the past five years. This stubborn pattern makes it difficult for the market to turn away lightly.

Columbia Threadneedle portfolio manager Ed Al-Hussainy said, “If you do nothing, do you have confidence that inflation will come down to 2% or 2.5%? The answer is no. The Fed should feel more confident about raising rates, without being overly concerned about downside risks.” He currently holds a position overweighting long-term bonds versus short-term bonds, and this strategy will benefit from the Fed’s more hawkish policy path.

U.S. Bank economists expect the Fed to raise rates at three meetings—September, October, and December. After the release of the June CPI data, the bank said in a client report that inflation is still far above the target. “We need to see several more pieces of data like this before we would reconsider our current judgment.”

The market has “done the work,” so Wossh can stand pat

The bond market’s self-driven repricing is objectively sharing the policy pressure faced by the Federal Reserve. DoubleLine’s deputy chief investment officer Jeffrey Sherman noted that, based on federal funds rate futures pricing, the bond market has often gotten ahead of the Fed’s actions in the past. The most important change now, he said, is that the market is no longer continuously pricing in rate cuts as it did over the past three years; instead, it has started to reflect the possibility of rate hikes in the coming year.

Sherman said this is in sharp contrast to the earlier policy cycles: “The market heard Powell announce the end of rate hikes and began to anticipate rate cuts, but rate cuts did not actually materialize.” Now, “it seems the market is saying: maybe the Fed will raise rates at some point in the next 12 months.”

In his view, this means Wossh may not necessarily need to take action right away. “What you’re seeing is that the market has essentially done the Fed’s job—the yield curve has developed an upward slope, with the policy rate below all other rates on the curve. So Fed Chair Wossh perhaps doesn’t need to take any action for the time being and can stand pat.” Sherman concluded, “The bond market is fulfilling its role—it’s sniffing out the data.”

Wossh’s hawkish stance is clear, but flexibility is deliberately preserved

Wossh took over as Fed chair two months ago, and since taking office he has consistently placed suppressing inflation as the top priority. At last month’s first post-meeting press conference, he repeatedly emphasized the necessity of bringing inflation under control; during congressional testimony last week, he reiterated again that the June CPI data does not mean the mission is complete.

Notably, Wossh did not provide a clear signal on the timing of rate hikes, and he tends to play down the Fed’s forward guidance on the interest-rate outlook. The reason is that overly explicit guidance may put policymakers in a passive position and make it harder to adjust flexibly. The Fed officials will enter a routine blackout period ahead of the two-day meeting starting July 28 this week, during which the market will lack new policy signals.

Since the last rate cut in December last year, the Fed has remained on hold. At that time, the labor market rebounded from its February low, and the Trump administration’s military action against Iran triggered a new wave of inflation shocks. As a result, broad market expectations for the Fed to restart rate cuts also fell through. Wossh made it clear that he would maintain the Fed’s political independence and would not yield to Trump’s pressure to cut rates.

Market divergence remains, and caution is still the main tone

Although rate-hike expectations dominate the market, some institutions are making more cautious assessments of the pace of the Fed’s actual actions. Chi Chen, co-manager of BlackRock’s $18 billion Total Return Fund, said, “The market’s pricing of the Fed’s policy path is more hawkish than we expected—provided that our view on disinflation and growth slowdown in the second half of the year is correct. The Fed may continue to maintain a hawkish stance and wait until the data ultimately becomes more moderate.” Her team currently leans toward allocating to intermediate- and short-term bonds, believing that after the selloff following the Iran war, “valuations are significantly more attractive than before.”

Sherman is also reserved about the threshold for a September rate hike, saying it would require “a large amount of data” to force the Fed to make that decision, especially with elections approaching and political pressure still present.

Al-Hussainy put it plainly: “This is not the time to take risks by sticking your neck out.” With the policy path still unclear, avoiding a heavy bet on the Fed’s sensitive positions may be the safest choice for now.