Rate hike is imminent! Walsh and the bond market reach consensus: the Fed's fight against inflation is far from over

Zhitong Finance APP noted that bond traders and Federal Reserve Chairman Kevin Walsh have reached a consensus on a critical issue: the Fed's fight against inflation still appears far from over.

The U.S. Department of Labor reported that U.S. consumer prices in June saw the first month-on-month decline since 2020, which brought relief to financial markets—as investors last week quickly closed their bets on the Fed possibly beginning rate hikes later this month.

However, this respite is likely to be temporary. After the collapse of the U.S.-Iran ceasefire agreement, oil prices have risen again. Although bubble concerns have hit some tech stocks, substantial spending in the field of artificial intelligence continues to inject stimulus into the economy. Walsh, who took over as Fed chairman two months ago, has made it clear that the central bank’s top priority is to bring inflation down—a target the Fed has missed for five consecutive years with inflation stuck above its 2% annual target.

As a result, traders still expect that the Fed will almost certainly initiate rate hikes before the end of the year, possibly as early as September.

Columbia Threadneedle portfolio manager Ed Al-Hussainy commented, "If you do nothing, are you confident that inflation will return to 2% or 2.5%? The answer is no." He is betting that long-term bonds will outperform short-term notes, a position that would benefit from a more hawkish central bank stance. “The Fed should be more comfortable raising rates without worrying about downside risks like before.”

Bond traders expect the Fed to raise interest rates soon

Since the last rate cut in December last year, the Fed has kept monetary policy steady—during that time, the job market rebounded from February’s weakness, and the war launched by Trump against Iran brought a new wave of inflationary shock to the global economy. These two major changes shattered the previously prevalent expectation that, even if Trump appointed Walsh to replace Powell—whom he had criticized multiple times for not lowering borrowing costs faster—the Fed would resume rate cuts.

Afterward, Walsh signaled his desire to maintain the Fed’s political independence and not give in to Trump’s pressure.

At his first post-meeting news conference as chairman last month, Walsh repeatedly stressed the need to bring inflation down. He reiterated this message on Capitol Hill last week, stating that the June Consumer Price Index data did not mean the Fed’s mission was complete. Three other regional Fed presidents—Jeff Schmid, Lorie Logan, and Beth Hammack—echoed a similar tone.

Although traders currently see little chance of a rate hike in July, they still see a high probability of a 25 basis point increase in September or October, and consider a hike before December as almost a done deal.

Even so, the impact on financial markets may be relatively mild, as Treasury yields have already risen in anticipation. Since the end of February, the two-year Treasury yield has jumped by about three-quarters of a percentage point to nearly 4.2%, well above the Fed’s rate range of 3.5%-3.75%.

The broad rise in Treasury yields has, in turn, pushed up costs for mortgages and other types of loans, which helps to slow down the economy and accomplish part of the Fed’s job.

Chi Chen, co-manager of BlackRock’s $1.8 billion Total Return Fund, said, “If our expectations of lower inflation and slower growth in the second half are correct, the market is pricing in a more hawkish path for the Fed than we anticipate. The Fed may remain in hawkish territory, waiting for the data to finally ease off.”

Therefore, her firm favors bonds with medium and short maturities—the yields of which rose after the sell-off following the Iran war. "Valuations are certainly more attractive than before."

The two-year Treasury yield rises above the Fed policy rate

Walsh has yet to reveal when the Fed will act. He also tends to downplay the central bank's forward guidance on interest rates, arguing that such guidance can make policymakers passive and reluctant to change course. This week, Fed officials won’t be releasing much new data or commentary either, as they enter their customary blackout period ahead of the two-day meeting starting July 28.

Strategist Edward Harrison said that if the Fed fails to bring inflation down, its anti-inflation "tools" won’t provide returns for investors either. With the yield curve continuing to steepen and long-end real yields not coming down, Tuesday’s bond rally still ominously appears to be a “relief rebound.”

Economists at Bank of America expect the Fed to raise rates in September, October, and December. In their report to clients after the June CPI data was released, they said that, given that inflation is still well above the Fed’s target, “We need to see a few more such data points before reconsidering our current view.”

Columbia Threadneedle fund manager Al-Hussainy said that given the uncertainty of the situation, it’s best to take a cautious approach and not place big bets on positions heavily affected by Fed actions. “Now is not the time to stick your neck out,” he said.