Market acts as a proxy for "rate hikes"; Walsh goes all out to "fight inflation"

```

The sharp rise in US Treasury yields has, to some extent, replaced the actual effect of rate hikes, while Federal Reserve Chair Walsh's hawkish stance has provided a clear anchor for this market pricing. A rare tacit understanding is emerging between the bond market and the Fed.

The US Consumer Price Index (CPI) for June recorded its first monthly decline since 2020, giving the market a brief sigh of relief and prompting a rapid closing of positions betting on a Fed rate hike this month. However, Walsh immediately made it clear on Capitol Hill that the June CPI data does not mean the anti-inflation task has been accomplished. Kansas City Fed President Jeff Schmid, Dallas Fed President Lorie Logan, and Cleveland Fed President Beth Hammack also sent out 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 its benchmark interest rate by 25 basis points in September or October, and a rate hike by year-end is almost seen as a certainty. Meanwhile, since the end of February, the 2-year US Treasury yield has climbed about 75 basis points to nearly 4.2%, much higher than the Fed’s current policy rate range of 3.5% to 3.75%. The rise in US Treasury yields has effectively acted as a brake on the economy by pushing up costs for mortgages and other loans.

Inflation Pressure Remains, Rate Hike Expectations Persist

Although the June CPI data brought a brief respite, market concerns about the inflation outlook have not dissipated. After the US-Iran ceasefire agreement fell apart, oil prices rose again; massive capital expenditures in the AI sector continue to inject stimulus into the economy, even as some tech stocks face bubble concerns. Inflation has remained above the Fed’s 2% annual target for the past five years, and this stubborn trend makes a policy shift difficult for markets to expect.

Ed Al-Hussainy, portfolio manager at Columbia Threadneedle, said: "If you do nothing, are you confident inflation will fall to 2% or 2.5%? The answer is no. The Fed should feel more confident about raising rates, without worrying too much about downside risks." At present, he is long on long-duration bonds over short-duration bonds, a strategy that will benefit from a more hawkish Fed policy path.

Economists at Bank of America expect the Fed to raise rates at its meetings in September, October, and December. After the June CPI release, the bank stated in a client report that inflation was still far above the target, and "we need to see several more similar data points before reconsidering our current judgment."

Market Has "Taken Over", Walsh Can Observe

The bond market’s spontaneous pricing is objectively helping share the Fed’s policy pressure. DoubleLine Deputy Chief Investment Officer Jeffrey Sherman pointed out that, based on forward pricing of the federal funds rate, the bond market has often led the Fed’s actions in the past, and the key change now is that the market is no longer persistently betting on rate cuts as it did over the past three years, but is beginning to reflect the possibility of rate hikes within the next year.

Sherman said this contrasts sharply with previous policy cycles: "The market hears Powell declare rate hikes are over and begins to expect rate cuts, but cuts never materialized." Now, "the market seems to be saying: maybe the Fed will raise rates sometime in the next 12 months."

In his view, this means Walsh may not need to take immediate action. "What you see now is that the market has actually already done the Fed’s job—the yield curve is upward sloping, and the policy rate is below all other rates on the curve. So, Chair Walsh may not need to do anything right now and can just watch and wait." Sherman summed up: "The bond market is performing its duty; it is sniffing out the data."

Walsh Is Clearly Hawkish, But Intentionally Retains Flexibility

Walsh became Fed Chair two months ago, and since taking office he has consistently made lowering inflation his top priority. At his first post-meeting press conference last month, he repeatedly stressed the need to control inflation; last week, during Congressional testimony, he again emphasized that June CPI data does not mean the mission is complete.

Notably, Walsh has not given a clear signal about the timing of rate hikes and is inclined to downplay the Fed’s forward guidance on interest rates, arguing that overly explicit guidance could leave policymakers in a passive position, unable to adjust flexibly. Fed officials will enter their customary quiet period before the two-day meeting starting July 28, so the market will lack new policy signals during this time.

Since the last rate cut in December last year, the Fed has kept rates unchanged. At that time, the job market rebounded from the February trough, and the Trump administration’s military action against Iran brought a new wave of inflation shocks. Previous market expectations for the Fed to restart rate cuts thus fell through. Walsh has stated clearly that he will maintain the Fed’s political independence and will not give in to Trump’s pressure for rate cuts.

Market Divergence Remains, Caution Still Prevails

Though rate hike expectations dominate the market, some institutions have a more cautious view on the pace of the Fed’s actual actions. Chi Chen, co-manager of BlackRock’s $18 billion Total Return Fund, said: "Market pricing for the Fed’s policy path is more hawkish than we expected, provided our outlook for inflation easing and growth slowing in the second half is correct. The Fed may continue to maintain a hawkish stance, waiting for data to finally turn moderate." Her team currently prefers positioning in medium-term and short-term bonds, considering that after the selloff following the Iran war, "valuations are obviously more attractive than before."

Sherman also holds a cautious view on the threshold for a September rate hike, believing it will require "a lot of data" to prompt the Fed to make such a decision, especially with elections approaching and political pressure lingering.

Al-Hussainy is blunt: "Now is not the time to stick one's neck out." In the absence of clarity on the policy path, avoiding heavy bets on sensitive Fed positions may be the safest choice right now.

Risk Warning and Disclaimer ClauseThe market carries risks, and investment must be cautious. This article does not constitute personal investment advice, nor does it take into account the specific investment objectives, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are appropriate for their specific circumstances. Invest accordingly at your own risk. ```