The Fed's July meeting may disappoint doves, Powell hints at a rate cut in September

Source: Jinshi Data

The market has fully priced in a Fed rate cut in September, but the big question for the July 30-31 FOMC meeting is: How clear will the FOMC signal?

Foreign media economist Anna Wong and others believe that communication at the July meeting will only provide initial hints of a September rate cut, with Fed Chairman Powell noting that a rate cut may be in the works "if the data develops as we expect." Economists believe the main reason for hesitation is simply that there is still 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 at the end of August, when he will have an extra month of employment and inflation data at his disposal.

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 data on economic activity have been slightly more worrisome. Overall, the committee is likely to view the balance of risks between its two objectives - price stability and maximum employment - as 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, "Continued progress has been made toward the Committee's 2% inflation objective." The committee may acknowledge the unexpected rise in the unemployment rate while noting that the unemployment rate remains low. The language on labor market conditions may be modified to say, "Job gains remain strong and, despite some increases in the unemployment rate, remain low."

In the second paragraph, the committee may raise the risks to maximum employment. Instead of 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 goals have shifted toward “balanced” — no longer “better balanced.”

Given that core personal consumption expenditures inflation fell to 2.6% year-over-year in June and the three-month annualized rate was 2.3%, some participants might push to remove the definition of “elevated” inflation. But economists don’t expect such an effort to succeed, arguing that more cautious members (who still make up the majority of the committee) might oppose it because they worry that it would undermine confidence in the Fed’s resolve to get inflation back to 2%.

The most important change might be this sentence from 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 on a sustained path toward 2%.” Economists think this sentence must be completely rewritten, with the new version summarizing the following:

The Committee is moderately confident that inflation is on a sustained path toward 2%.

The balance of risks has become more balanced.

The committee acknowledges that the current level of the policy rate is restrictive.

If data develop 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 concern about the labor market, because if that were the case, they should have cut rates immediately, not waited until September. Instead, officials want to make it clear that any rate cuts would be only fine-tuning of rates 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." The FOMC said at the time that given those factors, it would “act as appropriate to sustain the expansion.” Economists don’t see the current weakness in the economy as pronounced enough to warrant that degree of dovishness. But officials could now take a subtle, similar approach by describing a soft landing as the “most likely” outcome. At the news conference, economists expect Powell to hint only at a September rate cut, 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 would be appropriate soon, but not yet, economists say. Even if markets sound 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 volatility.

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 a rate cut will definitely be made in September. The minutes of the meeting, scheduled to be released on August 21, will provide a more comprehensive view of all participants, followed by Powell's opening speech at the Jackson Hole Annual Meeting in Wyoming, USA.

While the post-meeting statement from the June meeting 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, according to our natural language processing model, the Fed minutes’ policy orientation indicator scores very close to the level that indicates a rate cut.

2. Whether or not to cut rates in September will depend entirely on economic data

U.S. economic data has been weaker than expected, and the Fed continues to emphasize that its decisions depend on economic data. If most of these key economic data can stabilize, the FOMC may wait a little longer before cutting rates, and we think at least some members prefer this approach. But if the economic data is significantly weaker than expected, as in recent weeks, the probability of a rate cut in September will indeed increase significantly.

Overall, we still believe that terminal interest rate expectations are far more important to the overall market than the actual timing of the Fed’s rate cuts. If the Fed starts cutting 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. The 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 the secured overnight financing rate (SOFR) futures options expiring at the end of 2025 is relatively symmetrical. In May of this year, when the market expected the Fed to only cut rates by about 1.25% in this cycle, the left tail of the probability distribution was thicker. Today, the left-skewed distribution is far less obvious than before, but the reflected rate cut is 1% larger. We expect the skewness to eventually return to the May level to reflect the risk of a larger rate cut.

4. The bullish steepening of the US Treasury yield curve has just begun

The US Treasury yield curve tends to steepen significantly before the Fed cuts, but this trend will continue until the Fed's rate cut cycle is clearly coming to an end. The curve has reversed from its deepest inversion of the cycle, and the subsequent stagnation may be coming to an end. Whether the Fed enters a rate-cutting cycle in September or November, the rate of decline of yields at the long end of the curve is likely to be much slower than that at 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 terminal rates will be lower than the current 3.5%, which may lead to a more significant decline in short-term yields.

5. August non-farm payrolls data may be the last straw to trigger a rate cut

The Treasury market still pays the most attention to the employment situation report, which brings market volatility about 70% more than the second most important report. Earlier this year, retail sales surpassed CPI to become the second most important report in the Treasury market. Given the market's focus on the health of the US economy, it is not surprising that hard data such as retail sales and CPI outweigh survey-based data such as ISM.