CICC: The Federal Reserve remains on hold, increasing market risks

The Zhitong Finance App learned that CICC released a research report saying that the Federal Reserve kept interest rates unchanged at the July meeting, but internal hawkish forces further strengthened, and the three voting committees voted to raise interest rates by 25 basis points. The bank believes that the biggest change in this meeting was not the interest rate decision, but rather that Walsh tried to reduce policy intervention, rely more on spontaneous increases in market interest rates to tighten financial conditions, and “outsource” some austerity functions to the market. However, in a context where inflation continues to be above target, this approach can easily weaken the market's confidence in the credibility of the Fed's policies. After the meeting, long-term US bond yields rose sharply, and the curve steepened significantly, which may reflect investors starting to price higher long-term inflation and policy risks. Looking ahead, the bank believes that if employment or inflation data exceeds expectations, the market will not only further raise expectations for the September interest rate hike, but may also price the risk of the Federal Reserve “acting too late (too late).” Long-term interest rates will rise further, and risk assets will also face greater adjustment pressure.

CICC's main views are as follows:

The Federal Reserve's July meeting was on hold, but the hawks' strength is growing. The federal funds rate remained in the 3.5% to 3.75% range, in line with market expectations. The resolution was passed 9-3. Dallas Federal Reserve Chairman Logan, Cleveland Federal Reserve Chairman Hamak, and Minneapolis Federal Reserve Chairman Kashkari voted against it, advocating an immediate 25 basis point increase in interest rates.

Although interest rates remain unchanged in the end, the three negative votes themselves have sent an important signal — concerns within the committee about the risk of inflation are heating up. If the inflation data continues to rise above the 2% policy target, more officials will join the camp advocating interest rate hikes. In fact, in the past three weeks, quite a few officials have begun considering the option of “preventative” interest rate hikes, which has also kept the interest rate market's pricing high during the year.

The bigger change came from Walsh's remarks. He pointed out that since the last meeting, both nominal interest rates and real interest rates have risen markedly, and financial conditions have been tightened. As the Federal Reserve reduces forward-looking guidance, “market participants are learning to watch the ball rather than the referee (play the ball and not the referee).” Meanwhile, Walsh reiterated that the Federal Reserve remains committed to dealing with inflationary pressure and has no “soft inflation target” other than 2%.

This statement means that in Walsh's view, the Federal Reserve does not necessarily need to influence financial conditions by frequently adjusting policy interest rates, but can rely on the spontaneous rise in market interest rates to achieve the goal of curbing demand and reducing inflationary pressure. In other words, Walsh is trying to “outsource” some of the austerity functions to the market.

The bank believes that this kind of thinking is viable during a period when the economy is running smoothly, but when inflation continues to be above target and the market is highly sensitive to the central bank's reputation, it faces greater risks. This will cause the market to doubt whether the Federal Reserve has the credibility of its policies to fight inflation.

The market's performance also reflects this concern. After the interest meeting, the 10-year yield rose by about 8 basis points, the 30-year yield soared by 12 basis points, and the yield curve steepened markedly. Meanwhile, the US dollar index declined, gold prices rose, and US stocks plummeted. This may indicate that the market believes that the Fed lacks credibility, and investors are beginning to demand higher long-term risk premiums to compensate for future inflation and policy uncertainty. Seen from this perspective, although there were three negative votes at this meeting, it failed to prove to the market that the Federal Reserve is ready to take action to control inflation.

Looking ahead, the bank believes that the current standstill by the Federal Reserve not only did not ease the market's concerns about inflation; on the contrary, it may increase the volatility of the bond market and increase the risk of stock market adjustments.

First, today's market reaction is clearly not what the Federal Reserve would like to see. In order to maintain the credibility of the policy, it is likely that more Fed officials will release hawkish signals for some time to come. The bank expects that the three voting committees that voted against this time will continue to publicly support interest rate hikes, and there are still a number of hawkish or open officials within the committee, such as Governor Waller, Vice Chairman Jefferson, and Governor Cook. They may also mention interest rate hike options in future public speeches.

Second, abandoning this interest-rate hike window is not without cost; it leaves more pressure for the future. If employment, wage, or inflation data for the next month exceeds expectations, then the probability of interest rate hikes in September will increase further. At that time, the market will not only reprice the next rate hike, but will also begin to take into account the risk of the Federal Reserve “acting too late (too late)”, driving long-term US bond yields higher. In other words, even if the Federal Reserve does not raise interest rates this time, financial conditions will not necessarily relax; on the contrary, they may be further tightened by increasing market interest rates.

Of course, this is probably the effect Walsh wants to achieve — to cool down demand and reduce inflation through spontaneous adjustment of market interest rates without frequently adjusting policy interest rates. However, this approach is essentially trading greater market volatility in exchange for tighter financial conditions. In the current context of continued adjustments in AI assets and rising geographical risks in the Middle East, rising long-term interest rates may resonate with declining risk appetite, putting more pressure on risk assets, including stocks.