Investors are now increasingly confident that the Fed will raise interest rates at the FOMC meeting later this month, and that confidence is not without reason. Inflation data and the Fed Chair's own testimony will be the real deciders tonight.
Expectations for a Rate Hike Rise Suddenly
The market probability of a quarter-point rate hike this month has now increased to about 50 percent, compared to less than 10 percent previously. The two-year Treasury yield also confirmed the sentiment, remaining above 4.25 percent, well above the current policy rate.
According to our analysis, the probability of a rate hike this month is high. The Fed's targeted inflation rate is actually close to reaching its desired level, but to truly return to the two percent target requires more supporting factors.
Fed Governor Christopher Waller, who has been known as one of the most cautious officials on rate hikes, has also changed his stance. He himself admitted that an interest rate hike “in the near future” should be considered if core inflation continues to show high readings.
Tonight’s CPI Data Will Be Decisive
The Consumer Price Index (CPI) data for June is expected to be announced at 8.30 tonight. According to market expectations, it will record the first decline in the overall and core inflation rates since January. Both rates were at 4.2 percent and 2.9 percent in May, respectively.
The report is expected to show a 0.1 percent decline in overall prices compared to May, bringing the annual rate down to 3.8 percent from 4.2 percent. Core prices are expected to increase 0.2 percent compared to May and 2.8 percent compared to June last year.
The situation became more complicated when oil prices continued to rise on Tuesday, following the readiness of the US military to resume traffic restrictions to and from Iranian ports. President Donald Trump also confirmed that attacks on Iran would continue.
Warsh Remains Reluctant to Give Clear Guidance
Fed Chairman Kevin Warsh, who took office in May, is known for his reluctance to make any clear predictions about the direction of interest rates. This cautious stance has added to market uncertainty, especially since he is scheduled to testify before Congress on Tuesday and Wednesday.
Short-term interest rate markets are now fully pricing in one rate hike by the end of the year, and another by mid-2027. However, according to our analysis, these expectations may still not be enough, as the Fed is likely to completely reverse the three quarter-point interest rate cuts it made in the last four months of last year.
Impact on the Bond Market and Ringgit
Even if the CPI data comes out softer than expected, the relief in the bond market is expected to be limited. The two-year bond yield has risen by around 10 basis points this month, while the 10-year bond rose by 15 basis points, enough to erase the entire bond market gain for the year.
Our analysis also expects market confidence in the July interest rate hike to diminish slightly after the CPI data and Warsh's testimony this week. But Warsh's refusal to provide any clear indication of the extent of the decline in confidence has limited the extent of the fall in sentiment.
For the Ringgit, this development has its own repercussions. When the Fed is expected to continue to raise interest rates, the US Dollar usually becomes more attractive to investors. Therefore, even if the CPI data comes out soft, the pressure on regional currencies including the Ringgit is expected to continue as long as the Fed's policy stance remains uncertain.
Key Takeaways
The probability of a Fed rate hike in July has risen to 50 percent, from less than 10 percent a month ago.
The June CPI data is expected to show the first decline since January, to 3.8 percent overall and 2.8 percent for the core rate.
Fed Governor Christopher Waller is now backing consideration of raising interest rates if core inflation remains high.
US two-year and 10-year bond yields rose sharply this month, erasing the bond market's gains for the year.
Expectations of continued interest rate hikes have also supported the strength of the Dollar, which could potentially add to the pressure on the Ringgit.
As long as Warsh remains reluctant to give any clear guidance, the market is expected to remain cautious until the FOMC meeting on July 29, as each new data has the potential to change expectations in a short period of time.
