Source: Jinshi Data
The market has fully priced in a September rate cut by the Federal Reserve, but a big question heading into the July 30-31 FOMC meeting is: How clear will the FOMC signal?
Foreign media economist Anna Wong and others believe that the July meeting communication will only provide preliminary hints of a September rate cut , and Fed Chairman Powell will point out that a rate cut may be possible "if the data develops as we expect." Economists believe that the main reason for hesitation is simply that there is a lot of data to be released before the September 17-18 FOMC meeting - there are two inflation and employment reports before that, and the data may change a lot . The best time to clearly hint at a September rate cut will be Powell's speech at the Jackson Hole Central Bank Annual Meeting in late August , when he will have an extra month of employment and inflation data.
Economists' expectations for the July 30-31 FOMC meeting are that the FOMC will unanimously decide to keep interest rates unchanged at 5.25%-5.50%, despite calls from many Wall Street analysts for a rate cut. Inflation data since the June FOMC meeting have been encouraging, while economic activity data have been slightly more worrisome. All in all, the committee is likely to believe that the balance of risks between its two goals - price stability and maximum employment - is roughly even .
Economists expect some changes to the FOMC policy statement: In the first paragraph, they expect the FOMC to remove the word "modest" when describing inflation progress. Instead, they may say, "Progress toward the Committee's 2 percent inflation objective has continued." The committee may acknowledge the unexpected rise in the unemployment rate while noting that the unemployment rate remains low. The language about labor market conditions may be revised to say, "Job gains remain strong and, despite some increases in the unemployment rate, remain low."
In the second paragraph, the committee might raise the risks to full employment. Rather than saying, “The committee remains highly focused on inflation risks,” the new statement might say that the committee will focus on both inflation and employment risks. Officials might say that over the past year, the risks to achieving the dual objectives have shifted toward “balanced” — no longer “better balanced.”
Given that core personal consumption expenditures inflation fell to 2.6% year-on-year in June and 2.3% at an annualized rate for three months, some participants may push to remove the definition of "elevated" inflation . But economists do not expect such an effort to succeed, believing that more cautious members (who still make up the majority of the committee) may oppose it because they worry that it will undermine confidence in the Fed's determination to bring inflation back to 2%.
The most significant change may be the following sentence in the June statement: "The Committee judges that it would be inappropriate to reduce the target range for the interest rate until it is more confident that inflation is moving sustainably toward 2 percent." Economists believe that this sentence must be completely rewritten, and the new version summarizes the following points:
The Committee is moderately confident that inflation will continue to move toward 2%.
The balance of risks has become more even.
The Committee acknowledged that the current level of the policy rate is restrictive.
If the data develops as the committee expects, a rate cut would be "appropriate soon".
The trickiest part is that the Fed doesn’t want markets to think they’re cutting rates out of concerns about the labor market, because if that were the case, they should have done so immediately, not waited until September. Instead, officials want to make it clear that any rate cuts would be just tweaks to ensure a soft landing for the economy . One way to convey that is to borrow language from its June 2019 statement — just before the Fed began cutting rates the following month. At the time, the committee said it still viewed strong labor market conditions and inflation near 2% as “the most likely outcomes, but uncertainty about that outlook has increased.” Given those factors, the FOMC said at the time, it “will act as appropriate to sustain the expansion.”
Economists believe that the current weakness in the economy is not yet evident enough to warrant this degree of dovishness. But officials can now adopt a subtle similar approach by describing a soft landing as the "most likely" outcome .
At the news conference, economists expected Powell to hint only at a rate cut in September, and he is expected to give a clearer signal at his annual Jackson Hole speech in late August , when the Fed will have an extra month of inflation and employment reports.
All in all, most FOMC officials probably think a rate cut is appropriate soon, but not yet, the economists said. Even if the market sounds the alarm, "we don't think the economic data since the June meeting will be enough for officials to want to cut rates in July."
The Fed's July meeting may disappoint doves, but the U.S. Treasury yield curve is expected to steepen
The Fed may be slightly dovish at its July monetary policy meeting, but those who expect a clear signal of a rate cut in September may be disappointed. In any case, economists expect the U.S. Treasury yield curve to steepen further after some fluctuations.
1. The minutes will show that the Fed is ready to cut interest rates
Analyst Vera Tian said: The Fed's July meeting will pave the way for the September meeting, but the stance may be more neutral than the market expects. Since Powell can use the Jackson Hole Annual Meeting to adjust market expectations, we believe that the Fed will not rush to say that it will definitely cut interest rates in September. The meeting minutes scheduled for release on August 21 will provide a more comprehensive view of all participants, and Powell will then deliver an opening speech at the Jackson Hole Annual Meeting in Wyoming, USA.
While the June meeting statement and Powell’s opening remarks at the post-meeting press conference both reflected a fairly neutral policy orientation, the minutes were more dovish . In fact, our natural language processing model shows that the Fed minutes policy orientation indicator scores very close to a rate cut.
2. Whether the interest rate cut in September will depend entirely on economic data
US economic data has been falling short of expectations, and the Fed continues to emphasize that its decisions depend on economic data. If most of these key economic data stabilize, the FOMC may wait and see for a while before cutting interest rates, and we think at least some members prefer this approach. But if economic data is significantly below expectations as in recent weeks, the probability of a September rate cut will indeed increase significantly.
Overall, we still believe that the expectations of the terminal rate are far more important to the overall market than the timing of when the Fed actually starts to cut rates . If the Fed starts to cut rates in September, but the market's expectations for the terminal rate are still slightly below 3.5%, then the pricing of the long end of the curve and forward rates will not change.
3. Probability distribution of market expectations for the Fed’s path
The market currently expects the terminal rate to be around 3.5% by the end of 2025, and the expected distribution of risk outcomes reflected in options on SOFR futures expiring at the end of 2025 is relatively symmetrical. In May, when the market expected the Fed to cut rates by only about 1.25% this cycle, the left tail of the probability distribution was thicker. Today, the left-skewed distribution is far less pronounced, but reflects a 1% increase in rate cuts. We expect the skewness to eventually return to May levels to reflect the risk of a larger rate cut .
4. The steepening trend of the U.S. Treasury yield curve has just begun
The Treasury yield curve tends to steepen sharply before the Fed cuts, but the trend will continue until the Fed's rate-cutting cycle is clearly coming to an end. The curve has rebounded from the deepest inversion of the cycle, and the subsequent stagnation may come to an end. Whether the Fed enters the rate-cutting cycle in September or November, the long end of the curve is likely to fall much slower than the short end. But with funding rates still above Treasury yields, the 2-year/10-year Treasury yield curve will need to steepen by more than 20 basis points to generate positive returns.
We expect that over time, market expectations for the terminal rate will move below the current 3.5% level, which could lead to a larger decline in yields at the short end of the spectrum .
5. August non-farm payrolls data may be the last straw that triggers a rate cut
The U.S. Treasury market remains most focused on the employment report, which generates about 70% more volatility than the next most important report. Earlier this year, retail sales surpassed CPI as the second most important report for the Treasury market. Given the market's focus on the health of the U.S. economy, it is not surprising that hard data such as retail sales and CPI outweigh survey-based data such as ISM.
