Fed Preview: July Meeting May Disappoint Doves, Powell Will Only Hint at Rate Cut in September

The market has fully priced in the Fed's rate cut in September, but a big question at the FOMC meeting on July 30-31 is: How clear a signal will the FOMC send?

Foreign media economists like Anna Wong believe that the communication at the July meeting will only provide a preliminary hint of a rate cut in September. Fed Chair Powell will likely indicate, "If the data evolves as we expect," a rate cut may be possible. Economists believe that the main reason for hesitation is the significant amount of data to be released before the FOMC meeting on September 17-18—there are still two inflation and employment reports to come, and the data could change significantly. The best time for a clear hint of a rate cut in September is expected to be at the end of August during Powell's speech at the Jackson Hole central bank annual symposium, where he will have another month of employment and inflation data.

Economists' expectations for the FOMC meeting on July 30-31 are that despite many Wall Street analysts calling for a rate cut, the FOMC will unanimously decide to keep rates unchanged at 5.25%-5.50%. Inflation data since the June FOMC meeting has been encouraging, while economic activity data is slightly concerning. Overall, the committee may consider that the risk balance between its two goals—price stability and full employment—is roughly equal.

Economists expect some changes in the FOMC policy statement: in the first paragraph, they anticipate that the FOMC will likely remove the word "modest" when describing inflation progress. Instead, they may say, "The Committee has made sustained progress toward its 2% inflation target." The committee may acknowledge the unexpected rise in the unemployment rate while noting that the rate remains low. Language regarding the labor market conditions may be modified to say, "Job growth remains strong, and although the unemployment rate has risen, it remains low."

In the second paragraph, the committee may raise the risks to full employment. The new statement may indicate that the committee will now focus on both inflation and employment risks, rather than saying "the Committee continues to closely monitor inflation risks." Officials may state that over the past year, the risks to achieving the dual mandate have shifted to a "balance"—no longer a "better balance."

Given that core personal consumption expenditures inflation fell to 2.6% year-on-year in June, with a three-month annualized rate of 2.3%, some participants may push for the removal of the definition of inflation as "running high." However, economists do not believe such efforts will succeed, as they think more cautious members (still the majority on the committee) may oppose it, fearing it would weaken confidence in the Fed's determination to bring inflation back to 2%.

The most significant change may be the following sentence from the June statement: "The Committee believes that it is inappropriate to lower the target range for the federal funds rate until it has greater confidence that inflation will move up to 2%." Economists believe this sentence must be completely rewritten, with the new version summarizing the following points:

The committee has moderate confidence that inflation continues to move towards 2%.

The balance of risks has become more even.

The committee acknowledges that the current policy rate level is restrictive.

If the data evolves as the committee expects, a rate cut will be "appropriate soon".

The trickiest part is that the Fed does not want the market to think that they will cut rates out of concern for the labor market, because if that were the case, they should cut rates immediately, not wait until September. Instead, officials hope to indicate that any rate cut is just a fine-tuning of rates to ensure a soft landing for the economy. One way to convey this is to borrow the wording from the June 2019 statement—just before the Fed began cutting rates the following month. At that time, the committee stated that it still believed that a strong labor market and inflation near 2% were the "most likely outcomes, but the uncertainty around this outlook has increased." The FOMC at the time stated that, considering these factors, it "will take appropriate action to sustain the expansion of the economy".

Economists believe that the current weakness of the economy is not yet pronounced enough to support such a dovish stance. But officials can now take a subtle similar approach, describing a soft landing as the "most likely" outcome.

At the press conference, economists expect Powell to only hint at a rate cut in September, anticipating that he will give a clearer signal in his annual speech at the end of August at the Jackson Hole Symposium, by which time the Fed will have received another month of inflation and employment reports.

Economists say that overall, most FOMC officials may think that a rate cut soon is appropriate, but now is not the time. Even if the market sounds the alarm, "we do not believe that the economic data since the June meeting is enough to make officials want to cut rates in July".

Fed's July Meeting May Disappoint Doves, but U.S. Treasury Yield Curve Expected to Steepen

The Fed may be slightly dovish at its July monetary policy meeting, but those expecting a clear signal for a rate cut in September may be disappointed. Nonetheless, economists expect the U.S. Treasury yield curve to steepen further after experiencing some volatility.

1. Meeting minutes will show the Fed is poised to cut rates

Analyst Vera Tian said: The Fed's July meeting will set the stage for the September meeting, but the stance may be more neutral than the market expects. As Powell can adjust market expectations at the Jackson Hole Symposium, we believe the Fed will not rush to indicate a definite rate cut in September. The minutes scheduled to be released on August 21 will provide a more comprehensive view of all participants' opinions, followed by Powell's opening speech at the Jackson Hole Symposium in Wyoming, USA.

Although the post-June meeting statement and Powell's opening remarks at the post-meeting press conference were quite neutral in policy orientation, the minutes lean more dovish. In fact, according to our natural language processing model, the Fed meeting minutes' policy orientation indicator shows a score very close to the level representing a rate cut

2. Whether the rate cut in September will depend entirely on economic data

US economic data has been consistently below expectations, while the Federal Reserve continues to emphasize that its decisions depend on economic data. If most of these key economic data points can stabilize, the FOMC may choose to wait a while before cutting rates, and we believe that at least some members are more inclined to do so. However, if economic data remains significantly below expectations as it has in recent weeks, the probability of a rate cut in September will indeed increase significantly.

Overall, we still believe that market expectations for terminal rates are far more important to the overall market than the actual timing of the Fed's rate cuts. If the Fed initiates rate cuts in September but market expectations for terminal rates remain slightly below 3.5%, the pricing of long-term and forward rates will not change.

3. Probability distribution of market expectations for the Fed's path

The market currently expects the terminal rate to be around 3.5% by the end of 2025, and the risk outcome expectations reflected in the options on the Secured Overnight Financing Rate (SOFR) futures expiring at the end of 2025 are relatively symmetric. In May of this year, when the market expected the Fed to cut rates by only about 1.25% in this cycle, the left tail of the probability distribution was thicker. Now, the left-skewed distribution is not as pronounced as before, but the expected rate cut has increased by 1%. We expect the skewness to eventually return to the May level to reflect the risk of larger rate cuts.

4. The steepening trend of the US Treasury yield curve has just begun

The US Treasury yield curve often steepens significantly before the Fed cuts rates, but this trend will continue until the Fed's rate-cutting cycle clearly nears its end. The curve may plateau after rising from its deepest inversion level in this cycle. Whether the Fed enters a rate-cutting cycle in September or November, the decline in long-term yields may be much slower than short-term yields. However, as financing rates remain higher than US Treasury yields, the 2-year/10-year US Treasury yield curve will need to steepen by more than 20 basis points to generate positive returns.

We expect that over time, market expectations for terminal rates will be lower than the current 3.5%, which may lead to a greater decline in short-term yields.

5. August non-farm payroll data may be the final straw to trigger a rate cut

The US bond market still pays the most attention to employment situation reports, which bring about 70% higher volatility to the market than the second most important report. Earlier this year, retail sales surpassed the CPI, becoming the second most important report in the US bond market. Given the market's focus on the health of the US economy, the importance of hard data such as retail sales and CPI exceeds that of survey-based data like the ISM, which is not surprising