The Fed's July decision to hold rates steady, in a meeting lacking clear forward guidance, Fed Chair Powell's tolerant attitude towards the rise in long-term yields has become the market focus. Institutions generally believe this implies that Wall Street's spontaneous tightening is replacing official rate hikes.
At the just-concluded FOMC meeting, the Fed decided to keep the federal funds rate target range unchanged at 3.50%-3.75%. The meeting statement saw minimal changes, but notably three regional Fed Presidents (Hammack, Kashkari, and Logan) dissented, supporting a 25-basis-point rate hike.
Powell's welcoming stance towards the market's spontaneous tightening of financial conditions was explicit, stating that while the Fed hasn't done much in the past 42 days, the market has done a lot. As a result, the U.S. Treasury yield curve steepened significantly, with short-term rates remaining low against the backdrop of rising energy prices, while long-term rates rose sharply, with the 30-year bond yield briefly surpassing 5.20%.
Faced with the continued rise in long-term Treasury yields, Powell not only did not suppress it but instead believed that financial conditions had already tightened autonomously by the market. This implies that as long-term rates remain high, the necessity for the Fed to proactively hike rates will significantly diminish. Goldman Sachs, Barclays, and Nomura analysts believe that the Fed is tacitly allowing the bond market to replace official rate hikes, but this strategy could also raise long-term yields and sow the risk of anchored inflation expectations being lost and future policy turbulence increasing.
Lack of Guidance from the 'Dovish' Pause
Goldman Sachs analyst David Mericle pointed out in a report that prior to the meeting, there was the greatest uncertainty in thirty years about whether the Fed would hike rates, but the final meeting outcome seemed somewhat anticlimactic. Goldman Sachs believes that Powell's comments at the press conference overall leaned dovish and deliberately avoided providing clear policy guidance to the market.
Despite the lack of direct guidance, Goldman Sachs still extracted four key dovish signals from Powell's remarks.
First, Powell deliberately downplayed price pressures related to artificial intelligence, implying that price increases in these areas may be independent of a broader inflation trend. Second, when asked whether the recent rise in real interest rates indicated the market believed the Fed should hike, he attributed it to the economy's strong performance. Third, he repeatedly suggested that the rise in market rates could substitute for policy rate hikes. Fourth, Powell believed that, rather than suppressing demand through rate hikes directly, enhancing the Fed's credibility in achieving its inflation target could more effectively lower inflation expectations to reduce inflation.
Goldman Sachs expects that the recent softening in core inflation data over the coming months will lead the Federal Reserve to keep interest rates unchanged for the remainder of 2026. Currently, the bond market assigns a probability of around 60% to a rate hike at the September FOMC meeting.
Key Insight: Market-led Tightening in Lieu of "Rate Hikes"
The most critical signal in this decision that has captured Wall Street's attention is Powell's stance on the recent rise in bond market yields. Both Barclays and Nomura Securities emphasized in their reports that Powell not only refrained from pushing down long-term yields but instead welcomed the increase and strongly hinted that the rise in market rates could substitute for a substantial Fed rate hike.
Barclays highlighted that the Fed's own FRBUS model analysis shows that a significant rise in term premia can replace a higher federal funds rate. Powell explicitly stated during the press conference that the recent increase in nominal and real yields is one of the most significant shifts in the past twenty years. He attributed this to the strong economic performance and praised market participants for "learning to play the ball, not watching the referee," seeing it as a "positive change."
Goldman Sachs also picked up on this detail. When asked why the Fed chose to pause despite the strong economy, Powell responded directly that market rates "have not paused." He made it clear that although the Fed hasn't done much in the past 42 days, the market has done a lot.
Nomura Securities believes that Powell's approach of viewing financial conditions tightening as a policy substitute represents a "filterless" market signal preference. This implies that as long-term rates remain elevated, the Fed's urgency to actively initiate rate hikes will significantly diminish.
Rising Long-Term Yields and Inflation Expectation Risks
As the Fed has partially "outsourced" the task of tightening financial conditions to the bond market, Wall Street institutions are adjusting their investment strategies and are cautious of the potential risk of anchoring inflation expectations.
Barclays believes that due to increased uncertainty in the policy reaction function, the threshold for a Fed rate hike in September is rising, but the threshold for continued upward pressure on long-term yields has decreased. The institution points out that the 30-year Treasury yield breaking 5% is not a flash in the pan, and the current yield level has yet to fully price in the rise in the neutral rate, hence maintaining its investment recommendation for paying the 5-year forward-starting overnight index swap rate (5y5y SOFR).
Nomura Securities has issued a warning regarding the Fed's inflation credibility, noting that Powell's persistent dovish stance and vague interpretation of the policy reaction function could undermine the Fed's credibility in combating inflation. This directly resulted in a spike in the 5-year forward breakeven inflation rate post-meeting.
Nomura has warned that once there are signs of inflation stabilizing or the anti-inflation process faltering, the market may react more violently out of concern for the Fed's credibility. The risk of a long-term inflation expectation unanchoring may eventually force hawks within the FOMC to take a more aggressive stance.
Welcome to join the official BlockBeats community:
Telegram Subscription Group: https://t.me/theblockbeats
Telegram Discussion Group: https://t.me/BlockBeats_App
Official Twitter Account: https://twitter.com/BlockBeatsAsia
