Is a September rate hike the least bad option for the Federal Reserve?

Better-than-expected non-farm payroll data has pushed the probability of a Fed rate hike in September to 60%, putting Fed Chairman Warsh in a dilemma of whether to "let down the market" or "let down Trump".

In its latest report on September 8, Shenyin Wanguo Research pointed out that historical patterns show that once the market's expectation of an interest rate hike exceeds 40%, the hike has never failed to materialize. If this expectation fails to materialize, the term premium may rise sharply, and the market faces the risk of a "backlash".

The non-farm payroll data released on September 4th showed an increase of 162,000 jobs in August, far exceeding market expectations of 55,000, directly triggering a sharp repricing of market expectations for a Fed rate hike in September. Meanwhile, the rebound in oil prices and the stickiness of AI inflation mean that the probability of a significant drop in the August CPI is only about 10.6%, implying that the market's high expectations for a rate hike are unlikely to subside after the CPI data release.

Against this backdrop, Shenyin Wanguo Securities believes that a September rate hike may be the "least bad option" for the Federal Reserve at present. The cost of not raising rates may be an increase in term premiums and market backlash, while if the rate hike does not lead to a significant upward revision of the rate hike path, the impact on the market will be relatively limited.

Non-farm payrolls exceeded expectations, and expectations of interest rate hikes remain high.

Following the release of the August non-farm payroll data, market pricing in a September rate hike by the Federal Reserve quickly intensified. On September 3, after a speech by Federal Reserve Governor Christopher Waller, the probability of a September rate hike briefly fell to 50%; however, after the release of the non-farm payroll data, the probability rebounded to around 60%.

The August CPI data will be the last key variable before the September interest rate meeting. Historical data shows that only significantly lower-than-expected CPI data can lead to a substantial downward revision of market expectations for interest rate hikes. According to Shenyin Wanguo Securities, since 2015, when inflation is lower than expected, the market's expectation for an interest rate hike at the next meeting has been revised downward by an average of only 6 percentage points on the day the CPI is released. Historically, there have only been 13 instances where the expectation for an interest rate hike was revised downward by more than 10 percentage points on the day the CPI was released. Of these, only 3 occurred when inflation was flat or slightly higher than expected, and all of these were accompanied by external shocks such as the impact of the pandemic, unexpected dovish statements from Fed officials, or banking crises.

Currently, the August CPI faces dual pressures from energy and structural inflation. Escalating tensions between the US and Iran have disrupted passage through the Strait of Hormuz, causing oil prices to fluctuate and rise, with the US Gulf Coast crack spread climbing to $67.9 per barrel; AI-related service prices are also showing a structural upward trend. Shenyin Wanguo Securities conducted 10,000 Monte Carlo simulations based on four institutional forecasts, and the results show that the probability of a significantly lower-than-expected CPI is only about 10.6%.

Over 40% of the expectations have never failed to materialize; failure to do so could lead to a "backlash" from the term premium.

There is currently significant internal division within the Federal Reserve. This division intensified after the 9-3 vote at the July policy meeting. Recent statements indicate that Beth Hammack, Neel Kashkari, and Lorie Logan are relatively hawkish, continuing to call for rate hikes; Christopher Waller, John Williams, and others are relatively dovish; and Warsh himself stated on August 28 that "there is still work to be done" if core inflation does not improve significantly, showing signs of a hawkish shift.

Historical data is of significant reference value to Warsh's decision-making. According to Shenyin Wanguo Securities, in the 92 federal interest rate meetings since 2015, whenever the market's expectation of a rate hike exceeded 40% in the 10 trading days prior to the meeting, the rate hike never failed to materialize; a total of 20 such meetings saw the rate hike either occur as expected or exceed expectations. Only five instances occurred where the expectation of a rate hike was between 30% and 40%, but ultimately failed to materialize: September 2015, September 2016, May 2018, November 2018, and July 2026.

Of these five cases where the rate hike expectations failed to materialize, the situations in 2015 and 2016 were accepted by the market due to global risks and weak economic data. However, the cases in May 2018 and July 2026 are particularly alarming. These two cases were meetings held at the beginning of Powell and Warsh's terms when they were establishing the framework. After the rate hike expectations failed to materialize, there was a "backlash" of a sharp rise in the long-term term premium: in the 10 trading days after the rate hike failed to materialize, the 10-year term premium rose by 5.0 basis points and 6.2 basis points, respectively.

Trump's political pressure is also significant. As of September 3, Polymarket data showed a 51% probability of Democrats gaining control of the Senate, with both Democrats and Republicans projected to have 50 seats. Trump faces immense pressure from potential midterm election losses. However, Shenyin Wanguo Securities points out that historical data shows interest rate hikes have occurred three times in September since 1983 during midterm election years or in the year an incumbent president seeks re-election—a frequency no less than in "non-politically sensitive years." In 2018, Powell, newly nominated by Trump, also withstood political pressure and raised interest rates consecutively. Overall, market pressure may tilt Warsh's opinion towards interest rate hikes.

The impact of the interest rate hike will be limited; the key lies in whether the path of the hike will be revised upwards.

If the September rate hike proceeds as expected, historical patterns suggest that its impact on asset prices will be relatively limited in duration. According to Shenyin Wanguo Securities' analysis of asset performance after 51 rate hikes since 1990: US stocks typically exhibit a pattern of short-term corrections followed by medium-term recovery, with cyclical stocks performing relatively weakly; the 10-year US Treasury yield has fluctuated upwards, but the term premium has clearly declined.

The divergence in asset performance after an interest rate hike depends primarily on two factors: whether the hike exceeds expectations and whether the long-term path of the hike is revised upwards. Taking the 10-year US Treasury bond as an example, when the hike exceeded expectations, the yield fell by an average of 9 basis points in the following 20 trading days; conversely, when the hike was less than expected, the yield rose by an average of 28 basis points. When the long-term interest rate path shifted significantly upwards, the 10-year US Treasury yield rose by an average of 35 basis points in the following 20 trading days; while when the rate hike path remained relatively flat, the yield fell by an average of 5 basis points.

Shenyin Wanguo Securities believes that if the September rate hike slightly exceeds expectations, the market may view it as a relatively earlier-than-expected rate hike over the next year, and it may not necessarily lead to a significant upward revision of the rate hike path. The reasons are as follows: Firstly, the August non-farm payroll data was significantly affected by seasonal adjustments. Considering the low hiring rate, low layoff rate, and low labor participation rate, the US job market remains in a "weak equilibrium." Secondly, wage growth has not shown a significant upward trend, and current inflation is more structural than comprehensive, casting doubt on the necessity of multiple consecutive rate hikes. If the September dot plot guidance does not lead to a significant upward revision of the rate hike path, the impact of the rate hike on the market may be relatively limited, with a limited impact on short-term US Treasury yields, and the term premium may even marginally decline.

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