The Federal Reserve has become a "follower" in the market

The conditions for future rate hikes depend on new inflation indicators or evidence of inflation broadening; until then, interest rates will likely remain unchanged.

Written by: Li Jia, Wallstreetcn

The Federal Reserve under Walsh is rewriting market pricing logic.

On July 30, the macro team at China Merchants Securities, Zhang Jingjing and Wang Luobin, pointed out in their review of the July FOMC meeting that the real focus of this meeting was not keeping rates unchanged, but rather that Fed Chair Walsh systematically articulated a brand-new policy reaction function for the first time. Compared to the Powell era, the Fed is no longer willing to provide markets with clear policy guidance. Market rates themselves are increasingly replacing the federal funds rate as the main driver of tightening or easing financial conditions.

The July FOMC meeting kept rates unchanged, and the statement’s wording was barely adjusted, still emphasizing robust economic activity and strong productivity and capital investment. However, three officials—Hammock, Kashkari, and Logan—supported a 25 basis point rate hike, marking a rare three-vote dissent in recent years, also reflecting growing divergence within the committee regarding inflation risks.

China Merchants Securities believes that understanding the policy framework of the Walsh era is a key prerequisite for current market pricing. They stress that since the last two meetings, the nominal and real yields of US Treasuries have risen notably, meaning “the market has already completed part of the tightening for the Fed.” The impact of monetary policy on financial conditions is now transmitted more through market rates rather than the policy rate.

The Market Is “Hiking Rates” for the Fed

The report suggests that the reaction function in the Walsh era stands in stark contrast to the Powell era.

On one hand, the Fed no longer maintains high tolerance for inflation caused by supply shocks, but instead focuses more on whether inflation is spreading from localized to broad-based. On the other hand, compared to previously placing greater emphasis on employment and financial market volatility, Walsh gives more weight to the market’s own role in adjusting financial conditions, consciously downplaying the Fed's role as a “put option” for the market.

Under this framework, there are mainly two triggers for future rate hikes: first, the official introduction of new inflation measures showing a resurgence in inflation; second, confirmation that current high inflation is spreading to broader goods and services. Until then, keeping rates unchanged is still the baseline scenario.

China Merchants Securities also reminds that the US economy is entering a stage where “growth factors” and “recession factors” coexist and compete. Since the fourth quarter of last year, the US personal savings rate has dropped below 4%, while the marginal support from AI investment for economic growth may also weaken over the coming months.

For asset allocation, the report remains bullish on oil-related assets, and believes that if the AI industry chain shows positive signals, the Nasdaq still has room for a staged rebound. However, global capital expenditure growth may peak in the third quarter, and caution is needed for the fourth quarter. As for US Treasuries, with the Fed canceling forward guidance and the reaction function changing, the overall yield curve center is likely to continue moving higher; if expectations for future rate hikes strengthen further, a renewed inversion of the curve is worth monitoring in the medium term.