Fed faces 31% rate-hike odds as Warsh tests market with silence

The Federal Open Market Committee's two-day meeting concludes Wednesday with traders pricing a 31.5% probability of a quarter-point rate hike to a range of 3.75% to 4%, according to CME Group's FedWatch tool, while 68.5% expect the Fed to hold at 3.50% to 3.75%. The uncertainty is by design: Chair Kevin Warsh, who took office in May, has deliberately pulled back from the forward guidance that markets relied on under previous leadership.

"The upcoming FOMC meeting will be the first in quite some time that a large portion of observers will get an outcome they did not anticipate," wrote Padhraic Garvey, regional head of research for the Americas at ING. Warsh has created several task forces to examine changes in how the Fed conducts its business and has made clear he intends to provide much less steering of market expectations.

June's consumer price index rose at an annual pace of 3.5%, still well above the Fed's 2% target, though lower gasoline prices provided some relief. The fed funds rate has been unchanged at 3.50% to 3.75% since Warsh's first meeting in June, when the committee held steady and issued a deliberately sparse statement. Minutes from that meeting revealed a genuinely split committee, sending hike odds for the year surging from 35% to 57% within two days.

A surprise hike would allow Warsh to establish his anti-inflation credibility early in his tenure, several analysts said. At the European Central Bank's Sintra forum on July 1, Warsh warned that anyone expecting the Fed to tolerate above-target inflation would be disappointed. Dallas Fed President Lorie Logan has publicly said a July hike would be prudent, and Cleveland Fed President Beth Hammack has indicated inflation remains too high.

The Cross-Asset Stakes

The last time the Fed surprised markets with a rate hike was in June 2023, when the S&P 500 fell 1.2% on the day and the 2-year yield jumped 14 basis points. A similar outcome Wednesday could push the 2-year yield above 4.2% from its current level near 3.9%, while the S&P 500 — already under pressure from stretched tech valuations — could extend its July decline.

Citadel Securities' head of macro strategy, Frank Flight, published a research note calling for a surprise hike, arguing "the market may once again be underestimating the extent of the hawkish shift at the Fed." Flight said Warsh could use a July hike to "emphatically end the forward guidance era" and demonstrate commitment to Fed independence.

Bank of America Senior Economist Stephen Juneau said in a research note that he believes Warsh could assemble the necessary votes on the 12-member FOMC to move forward with a hike if he wanted to.

The New Normal or a Transition Phase?

Some of the current haziness is likely temporary, according to Joseph Abate, U.S. rates strategist at SMBC, since markets have not yet learned to read Warsh. "As he speaks publicly more often, markets will become more familiar with his thinking and which data he is watching," Abate wrote.

But Warsh's inclination to avoid discussing future policy moves may make it structurally harder for markets to map out his reaction function, Abate added. Barclays Economist Jonathan Millar warned that the lack of guidance means "markets are filling the void with speculation that Warsh may be eyeing a surprise hike." The risk, Millar wrote, is that market expectations become self-fulfilling, with Fed officials facing "growing pressure to deliver a hike regardless of whether incoming data" supports it.

Morgan Stanley Chief U.S. Economist Michael Gapen sees the Fed staying on hold, noting that "inflation has shown enough improvement to buy more time." But he acknowledged that if Warsh "may have a much more hawkish reaction function than we think," a hike becomes possible.

The FOMC will release its decision at 2 p.m. Wednesday, followed by Warsh's press conference at 2:30 p.m. OIS markets currently price a 69% probability of at least one hike before year-end, up from 35% before the June meeting.

This article is for informational purposes only and does not constitute investment advice.