TD Securities warns: Market misprices rate hike risk, Fed holding steady may weaken the dollar

According to Zhitong Finance APP, TD Securities stated that if the Federal Reserve keeps interest rates unchanged this week, the US dollar will weaken. Howard Du, a strategist at the institution, said that the extent of the dollar's specific decline will depend on whether all Fed policymakers support Fed Chair Kevin Walsh's stance. He believes that the market is mispricing the risk of a Fed rate hike and stated: "If the Fed decides to keep interest rates unchanged and there are no more than two dissenting votes, as event risk premiums subside, the US dollar should experience a short-term decline."

Expectations of a Fed rate hike and safe-haven demand triggered by the Middle East conflict have driven the US dollar index up nearly 3% since the end of February. According to the latest report from the US Commodity Futures Trading Commission (CFTC), speculative forex traders—including asset management institutions and non-commercial traders—have recently increased their long positions on the US dollar. Currently, their bullish sentiment on the US dollar has reached the highest level since 2015. Commenting on this, Du said: "The current US dollar long positions already include part of the market risk premium for a potential hawkish outcome at the July Fed meeting."

Du added that if there are no dissenting votes in the Fed's July rate decision, "this would surprise the market and indicate that Walsh may have successfully forged a certain level of consensus, which should result in a relatively more pronounced short-term sell-off in the dollar." TD Securities expects that if Fed policymakers remain united at this meeting, the US dollar index will drop by 0.5%.

Although "hawkish momentum is building," TD Securities strategists expect that Wednesday's Fed meeting may see two dissenting votes from Cleveland Federal Reserve Chair Beth Hammack and Dallas Fed Chair Lorie Logan. In this scenario, the institution expects the US dollar index to fall by 0.3%.

Strategists stated in their report: "Tensions in the Middle East are driving up oil prices, increasing inflation risks, and strengthening the case for rate hikes. However, we believe more evidence is needed to win over most policymakers."

Walsh will announce his second rate decision since taking office at 2 a.m. Beijing time on Thursday. Global capital markets are holding their breath amid unprecedented suspense. Just a month ago, the market was almost convinced the Fed would stand pat in July. Now, CME’s ‘FedWatch’ tool shows the probability of the Fed raising rates by 25 basis points this week has surged from 13% a week ago to over 30%.

Cooling US June CPI data once convinced the market that the Fed could continue to hold rates. But as Middle East tensions reignited and oil prices surged, Brent crude has risen 25% since the Fed’s June meeting. The rise in oil prices quickly passed through to gasoline and diesel prices, pressuring both consumers and US industrial costs. Meanwhile, the Trump administration on July 24 announced tariffs of 10% to 12.5% on 60 countries as an alternative after the Supreme Court previously struck down “Liberation Day” tariffs. In addition, the sustained strong demand for artificial intelligence (AI) investment is driving related demand higher. These three factors combined have reversed the market’s judgment on cooling inflation.

Citi bluntly stated that this is “the moment of greatest divergence since September 2024.” Data show open interest in federal funds futures soared further to 967,136 contracts on Monday after reaching 909,714 last Friday, hitting a new all-time high. Normally, expectations for the policy outcome are highly aligned before the meeting at this point, but this time, it’s completely different.

The biggest variable in this meeting comes from Walsh himself. Since taking office on May 22, Walsh has upended the Fed’s communication paradigm. He explicitly committed to abandoning “forward guidance”—no longer signaling the rate path to the market in advance. At the July 15 Congressional hearing, he refused to offer any specific views on rate moves in the coming months.

The consequences of Walsh’s approach are becoming evident—the market has lost the “policy compass” it’s been accustomed to for the past decade or so. Goldman Sachs points out that investors see “exceptionally high uncertainty” ahead of the July FOMC meeting, precisely because of divisions within the Fed and Walsh’s own still-uncertain stance.

However, some analysts believe Walsh himself may not support a rate hike right now. In his Congressional testimony on July 15, he described energy price shocks as “specific shocks to specific prices that we cannot control.” In addition, the June CPI saw its first decline in six years, and job growth is slowing, providing ground for staying put. A survey of 76 economists by the institution found that all respondents expect the Fed to keep rates unchanged.

For Walsh, the test he faces is vowing “zero tolerance” for inflation in Congress, while still being reluctant to reveal a specific path. As BlackRock previously noted, Walsh “recognizes that credibility remains the central bank’s most powerful policy tool,” but “these words ultimately need to be backed up by action.”