The probability of interest rate hikes in September was close to 100% nine months ago—acting early incurs lower costs to tame the market, and ultimately, the number of necessary rate hikes may even be fewer.

Written by: Huatai Reserch, Wall Street Insights

Core Viewpoints

After Kevin Warsh took office as the new chairman of the Federal Reserve, the financial market's pricing of this new chairman's policy orientation shifted from a previous dovish stance advocating rate cuts to a more hawkish short-term position. However, as the July policy meeting approaches, market expectations for the Fed's next policy step have become extremely divided. Following Warsh's abolition of forward guidance, market pricing has become more difficult, and the focus of the game between Warsh and the markets is bound to shift from "listening to what he says" to "observing what he does." By comprehensively analyzing the experiences of past Federal Reserve chair turnovers, the current macro environment, and Warsh's goal of gaining credibility, we have brought forward our forecast for the timing of the Fed's interest rate hikes—we expect the probability of a rate hike in July to be slightly above 50%, higher than the market's current expectation of 40%, and under the baseline scenario, the probability of a rate hike before September is close to 100%. From the perspective of the new chairman and the market's game, the overall cost of a rate hike in July may be lower.

1. Warsh's Primary Short-Term Goal is to Reshape the Credibility of the Fed, "Make the Dollar Great Again"

In Warsh's "debut" at the FOMC on June 17 and in several subsequent speeches, he emphasized the Fed's determination to undergo a series of policy reforms. Warsh's statements suggest that market expectations had previously leaned more hawkish, with a greater focus on long-term reforms. Two weeks after Warsh's FOMC debut, the market's pricing for interest rate hikes over the next 12 months rose by 15 basis points, resulting in a short-term rebound in the credibility pricing of the dollar and U.S. Treasury bonds: manifested through a temporary decline in the 10-year Treasury yield and inflation expectations, a drop in long-term rates, a compression of U.S. Treasury yield spreads, and a short-term weakening of gold and the Swiss franc against the dollar.

From the short-term forecasting perspective, Warsh's two main statements are key variables: ① a "zero tolerance" approach to exceeded inflation; ② the abolition of forward guidance. Anchoring long-term bond rates is more important than preventing short-term volatility. In the medium to long term, Warsh advocates reducing the size of the Fed's balance sheet and strengthening the liquidity management of the dollar, thereby reshaping the dollar's credibility as a reserve currency.

2. There is a Process of Market Adaptation and "Exploration" Following Each New Fed Chair's Appointment

In the early stages of every Federal Reserve chair's tenure, there is generally a period of increased market volatility, especially in the bond market—this can be understood as a process for the market to "adapt" to the new chair or for the new chair to gain the market's trust. We reviewed the experiences of the past eight Federal Reserve transitions and conducted scenario analysis based on the current situation. If nominal growth accelerates but the policy is dovish, the Fed/dollar "credibility indicators" may weaken across the board; conversely, if growth accelerates but the policy is hawkish, the stock market's enthusiasm may decline but still have fundamental support, leading to a strengthening of the Fed/dollar credibility indicators, similar to what transpired during the initial tenure of Volcker and Greenspan.

3. Highly Uncertain July Policy Meeting and Its Scenario Analysis

Before the July policy meeting, market expectations fluctuated again: the anticipation of interest rate hikes initially dipped and then rose with the release of inflation and employment data and an escalation in U.S.-Iran conflicts; at the same time, with the abolition of forward guidance, market "anxiety" increased, resulting in a renewed weakening of the Fed's credibility indicators and a resurgence in long-term U.S. Treasury yield levels.

Overall, an earlier interest rate hike may better serve Warsh's primary short-term goal, while a later hike may incur higher costs to "tame the market." First, from a game theory perspective, an "unexpected" choice would help the market break its dependence on forward guidance. Secondly, from the perspective of monetary policy credibility, leading or synchronizing rate hikes with the curve is conducive to lowering risk premiums, meaning that a rise in short-term rates helps to lower long-term rates, especially in an environment of unstable inflation expectations. If no rate hike occurs in July, and Warsh strictly implements the "new paradigm" of abolishing forward guidance, then the bond market may begin to price in Warsh's "bluff" and even tentative moves to loosen financial conditions, forcing a rate hike in September and potentially increasing the needed magnitude of that hike; whereas if a rate hike occurs in July, its main intention may be to establish credibility rather than to convey a signal of imminent continuous rate hikes.

In summary, we have revised our forecast for the timing of the Fed's interest rate hikes from the previously expected two hikes in the first half of 2027 to one or two hikes in the second half of this year, cumulative hikes before mid-next year (including this year). The main risks we foresee are: ① Warsh ultimately chooses to "bluff," allowing inflation expectations to rise; ② the AI boom "suddenly halts," leading to significant corrections in growth expectations and risk asset prices, naturally bringing economic growth back to a trend level (or even lower).

In the medium to long term, the structural contradictions of U.S. Treasury credibility and fiscal sustainability cannot be resolved by the Fed alone.