Author: Huohuo
Will rates be raised tonight? Economists say no, but the market assigns a 30% probability.
TL;DR
· A Reuters survey showed economists unanimously expected no rate hike in July, but futures markets at one point priced in about a 30% chance of a hike.
· The disagreement centers on whether oil price shocks will force Warsh to maintain the inflation credibility with a more hawkish communication.
· Underlying assets: U.S. Dollar Index, USD/JPY, WTI/Brent crude oil, gold, U.S. stocks, Bitcoin, and crypto assets.
Federal funds futures have been repriced ahead of the July FOMC decision, with traders paying more for the possibility of an unexpected rate hike or a more hawkish signal from the Federal Reserve.
The anomaly lies in the fact that economists’ forecasts were almost entirely on the other side. According to a Reuters survey on July 21, all 104 economists predicted that the July meeting would maintain the target range at 3.50%–3.75%, with 78 expecting it to remain unchanged through the end of the year. Yet the futures market at one point implied a roughly 30% probability of a 25-basis-point rate hike.
For investors, this isn't about guessing the outcome of a single meeting. The bigger question is whether the market is reevaluating how the Fed responds to oil price shocks since Kevin Warsh took office on May 22.
If Warsh views the Middle East situation driving up oil prices as a temporary supply disruption, the Fed is more likely to hold rates steady and wait for more data. If he is more concerned about oil prices triggering secondary inflation, even if no rate hike occurs tonight, he may reopen the window for a September hike.
In the futures market, buyers are taking on hawkish tail risk.
Federal funds futures can be understood as contracts betting on the Federal Reserve's interest rate path. The higher the open interest, the more capital is being deployed to bet on or hedge against the outcome of the decision.
According to CME and media data, open interest in federal funds futures rose to elevated levels ahead of the decision. This signal does not mean that most market participants expect a rate hike, but it indicates that uncertainty ahead of the decision has been traded into crowded positions.
The probability of a 25-basis-point rate hike follows the same logic. The probabilities from CME FedWatch are derived from 30-day federal funds futures prices, not from economists' votes. A probability of about 30% means that tail risk has suddenly become more expensive.
The market may not believe the Fed will act tonight. Instead, it seems to be hedging against two types of surprises: one is an immediate rate hike, and the other is no hike, but a statement and press conference suggesting that a September rate increase is now under serious consideration.
This is straightforward for asset pricing. The dollar will be supported by interest rate expectations. If the yen continues to face pressure at high levels, the risk of intervention will be reconsidered. Highly valued stocks and crypto assets will face higher discount rates and weaker risk appetite.
BofA and Citi are competing over oil price weightings.
The disagreement between hawkish and dovish institutions is not whether oil prices have risen, but how the Federal Reserve should respond to this increase.
According to Reuters on July 27, institutions such as BofA and Deutsche Bank still view July inaction as the baseline scenario, but believe oil prices and the Middle East situation have brought this meeting close to a dilemma. BofA’s concern is that if the Fed completely downplays oil price pressures, it could undermine its inflation credibility.
This logic underscores the new chair’s first stress test. With Warsh just appointed, the market lacks sufficient data to gauge his policy limits. If he appears too relaxed in the face of geopolitical shocks and inflationary pressures, investors may question whether the Fed still prioritizes taming inflation.
Institutions like Citi lean toward an alternative interpretation. The rise in oil prices is primarily a supply shock, with price pressures stemming from concerns about energy supply, not overheated U.S. demand. Raising interest rates cannot produce more crude oil, and an overreaction could instead dampen growth.
The core concept is second-round inflation. A rise in oil prices alone may be a short-term disruption, but if it spreads to transportation, goods, wages, and inflation expectations, it becomes a more persistent price pressure. Hawks are concerned about the latter, while doves believe we have not yet reached a point where rate hikes are necessary.
So, what the market is really debating is not oil prices themselves, but the weight of oil prices within the Fed’s reaction function. Will Warsh treat it as temporary noise, or as a credibility risk that needs to be preemptively contained?
The new chair expanded the path pricing.
What makes Wash's tenure unique is that the market has not yet developed a stable expectation of his communication style. During Powell's era, investors were accustomed to seeking path hints from wording, the dot plot, and press conferences. In this new chairmanship phase, every statement carries heightened weight.
If the Fed reduces forward guidance and repeatedly emphasizes data dependence, the market appears to gain flexibility but actually bears a wider interest rate distribution. Traders, unable to be confident that the policy path will remain stable until the next meeting, must hedge earlier.
This also explains why economists can unanimously predict no change tonight, while the market still prices in rate hikes. Economists answer the most likely outcome, but the trading market pays for adverse scenarios. They are not measuring the same question.
For the US dollar, as long as Warsh does not clearly reduce the likelihood of rate hikes, the dollar’s strength remains supported. For the yen, if the expected interest rate differential between the US and Japan continues to widen, the elevated USD/JPY level may test the Japanese authorities’ tolerance.
For risk assets, the most uncomfortable combination is not the rate hike tonight itself, but the simultaneous occurrence of rising oil prices, a stronger dollar, and the Fed’s reluctance to rule out further hikes in advance. This would compress valuations, liquidity expectations, and risk appetite.
Even if the Federal Reserve keeps its target range unchanged at 3.50%–3.75%, assets could still trade as if the outcome is hawkish if the statement prioritizes inflation risks or if Warsh declines to downplay the possibility of a September rate hike during the press conference.
The September window determines how far this pricing can go.
The baseline scenario remains a hold. Current market movements reflect traders significantly reassessing the policy path and communication risks, but do not indicate that the Fed has decided to restart the rate-hiking cycle.
The press conference will verify how Warsh defines oil price shocks. If he emphasizes that rising energy prices still require monitoring and that long-term inflation expectations remain anchored, market pricing for hawkish moves in July and September may ease, and the dollar’s rally could cool.
If he repeatedly emphasizes that oil prices may transmit to broader prices and places returning inflation to 2% at the top of the policy priority, the market will interpret this as opening the September window. At that point, even if rates remain unchanged tonight, the focus of trading will shift to whether the next meeting requires repricing.
The yen will be the most sensitive external pressure gauge. If USD/JPY continues to rise, the risk of Japanese intervention will become the boundary that dollar bulls must confront. For U.S. equities and crypto assets, the pressure is not in a single meeting, but in whether the market begins to accept a higher and more prolonged interest rate path.
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