How to view the current interest rate hike expectations?

The current market pricing for the Federal Reserve's monetary policy is showing a clear contradiction: US inflation data is weakening at the margin and tech stocks have sharply corrected, which should in theory reduce rate hike expectations. However, statements from Federal Reserve officials have shown no obvious shift in stance. Coupled with the dramatic escalation in US-Iran geopolitical risks over the weekend and a rebound in energy prices further raising inflation concerns, the market is currently pricing in about 1.3 Fed rate hikes within the year, with a total rate hike of 40bp over the next year.

1. Fed Officials Maintain Hawkish Rhetoric

Last week's US inflation data showed a decline, but this did not change the Fed officials' anti-inflation stance, and the recent policy statements overall remain hawkish. Fed Chair Warsh stated clearly at a Congressional hearing that he will firmly defend the 2% inflation target, and current CPI data is not sufficient to declare victory in the fight against inflation, dispelling market doubts about policy independence.

The FOMC meeting silent period began on July 18 (meeting held July 28-29). Currently, the market is pricing less than a 15% chance of a rate hike at the July meeting, and it is most likely a "hawkish pause" which may signal the possibility of further rate hikes in the future.

2. Tech Stock Plunge May Diminish Need for Rate Hikes

The massive capital expenditure and wealth effect caused by the previous surge in tech stocks was one of the main reasons Fed officials worried about a "second wave of inflation". The sharp decline in tech stocks can suppress some overheated capital investment, reduce the wealth effect for households, and decrease consumption, which helps to ease upward inflationary pressure. Additionally, if the stock market continues to drop, it may spill over into tighter credit conditions, effectively tightening market liquidity in place of the Fed, thereby reducing the need for rate hikes.

The key data to monitor in the market going forward is focused on the financial results of tech giants, with both Google Alphabet and Tesla set to report after the close on Wednesday. The market will focus on whether leading cloud providers and tech companies continue to ramp up capital spending on AI. If tech companies cut back spending or slow their expansion, it will further tighten financial conditions and significantly weaken the case for rate hikes within the year; if AI capital spending remains high, it could reignite inflation concerns and support rate hike expectations.

3. Oil Price Rebound Lifts Inflation Expectations

Under the influence of geopolitical turmoil, short-term inflation risks have increased once more. Last week, the US-Iran memorandum of understanding expired and maritime blockades were reinstated. Over the weekend, the US and Iran carried out consecutive tit-for-tat attacks related to US military casualties, pushing Brent crude oil prices above $90/barrel and European natural gas prices surged 5.3% at today's open. With global oil inventories at extremely low levels, the renewed strait blockade will directly boost inflation expectations.

However, currently there is strong market anticipation of another TACO. At present, Trump's main focus is the mid-term elections, so the potential for oil prices to rise significantly is limited.

4. Subsequent Market Outlook

In the writer's view, the current rate hike expectations for the year remain too high.Both the June US employment and CPI data weakened, clearly signaling a cooling real economy. Combined with the recent sharp decline in tech stocks tightening financial conditions, the fundamental need for additional Fed rate hikes this year is reduced.

However, for a clear drop in rate hike expectations, more triggers are needed. Potential triggers include: (1) If geopolitical tensions ease and oil prices continue to fall; (2) July's nonfarm payrolls data weakens again, confirming signals of economic slowdown.

Chart: The US Economic Surprise Index has started to flatten