Fed Expected to Hold Rates Steady, Warsh May Signal Hawkish Stance

Source: Jinshi Data

As Federal Reserve officials convene for their monetary policy meeting this week, they face a critical debate: facing inflationary pressures that show no clear signs of subsiding in the short term, what actions can and should the central bank take, and how will it choose to act.

The Federal Open Market Committee (FOMC) will announce its decision at 2:00 a.m. Beijing time on Thursday. Markets broadly expect the Fed to hold the benchmark rate steady, following a 25-basis-point hike in September. However, the real focus for investors is how policymakers will signal future actions, particularly what signals Fed Chair Kevin Warsh will send.

Brett Ryan, Senior U.S. Economist at Deutsche Bank, stated he will closely watch how Warsh describes the future monetary policy path. Warsh has consistently resisted revealing policy direction in advance, hoping the Fed will reduce its reliance on "forward guidance" and stop frequently previewing policy moves to the market as it has done since the 21st century.

In a report to clients, Ryan wrote that Warsh may hint that recent inflation data further validates the assessment from the September meeting: as time goes on, the Fed may still need to further tighten policy. However, skipping an October rate hike would also give officials more time to assess changes in the data.

Inflation Re-heats, Housing and Labor Markets Under Pressure

Recently released inflation data has done little to ease price pressures that escalated earlier this year.

The Consumer Price Index (CPI) shows that the U.S. headline inflation rate rose 3.7% year-over-year in September, primarily driven by a surge in energy prices. Excluding volatile food and energy prices, core CPI increased 2.6% annually, remaining above the Fed's 2% inflation target and up 0.3 percentage points from August, indicating that price pressures have not fully subsided.

Meanwhile, mortgage rates exceeding 7% continue to weigh on the U.S. housing market. The labor market presents a "low layoffs, low hiring" environment: layoff numbers are near their lowest level since the late 1960s, yet job seekers still face significant difficulty finding new employment.

Against this backdrop, adjusting monetary policy becomes particularly complex. Pausing rate hikes allows the Fed to assess the extent to which previous tightening measures have impacted the economy and financial conditions; however, if inflation remains stubbornly high, the Fed may be forced to raise rates further. Should that occur, the housing market, consumer loans, and other interest-rate-sensitive sectors could face even greater pressure.

Warsh aims to cultivate a more flexible approach within the Fed's policy stance, reluctant to commit prematurely to a future rate path, preferring instead to let the market gauge policy direction based on subsequent data releases. The challenge lies in the Fed needing to demonstrate its resolve to control inflation without locking in the pace and magnitude of future hikes too early.

Economists Warn: Policy Execution Risks Rise

Krishna Guha, Chief Economist and Central Bank Strategist at Evercore ISI, believes there is considerable risk of missteps in the current policy environment.

Guha noted in a Monday report that while Warsh remains vigilant to market risks and should theoretically project calm and steady leadership, the Fed faces significant challenges in policy execution.

He pointed out that the Fed has not adequately explained how it weighs the risks to its dual mandate—maintaining low inflation and achieving maximum employment—nor clearly articulated how it assesses the current degree of monetary tightening. These informational gaps make it harder for the market to anticipate the Fed's next move.

Despite persistently hot inflation, the U.S. unemployment rate remains broadly stable. Meanwhile, financial conditions are shifting. The Chicago Fed National Financial Conditions Index indicates that conditions have tightened slightly since the September rate hike, with heightened equity market volatility being one contributing factor.

Recent comments from key officials such as Vice Chair Jefferson and New York Fed President Williams point to a possibility: if inflationary pressures persist, the Fed might adopt a pattern of hiking rates every other meeting. Yet, how many additional hikes will ultimately be required remains unclear.

Guha believes Warsh's recent remarks at World Bank and IMF events in Bangkok largely align with the prevailing view within the FOMC. This suggests the Fed may adopt a cautious, methodical tightening pace, using one quarterly hike as a baseline scenario, adjusting judgments based on incoming data rather than ruling out any rate levels in advance.

He added that if inflation data continues to disappoint or economic momentum fails to weaken, the Fed may proceed with further rate hikes.

Markets Bet on December Hike as Economists Diverge

According to CME Group's FedWatch tool, fed funds futures imply roughly a 10% probability of a rate hike at this week's meeting, while the odds of a December hike exceed 80%. Markets also see some likelihood of another hike in March 2027, and approximately a 50% chance of one additional hike by the end of 2027.

However, economists remain sharply divided on whether the Fed should continue tightening policy.

Citi economists argue that inflation data may ease over the coming months, providing justification for the Fed to hold steady, potentially paving the way for rate cuts to begin next year. Nevertheless, Citi currently still forecasts a Fed rate hike in December.

Mohamed El-Erian, Chief Economic Advisor at Allianz, expects the Fed will ultimately hike rates, though he considers this course of action misguided, arguing that higher borrowing costs could damage vulnerable sectors like housing and exacerbate economic inequality.

Telling CNBC on Monday, El-Erian stated that the market's bet against a Fed move this time was correct, but Warsh must employ fairly hawkish rhetoric to justify the decision, given that inflation data has come in broadly above expectations.

He argued that addressing inflation concerns and rising U.S. Treasury yields should rely on "fiscal restraint, rather than monetary tightening". If the Fed ultimately opts to tighten further, it is not just the tech sector that could feel the impact. El-Erian noted that while tech may be relatively shielded, housing markets, auto loans, and personal consumer lending could face substantially heavier headwinds.

For the Fed, the crux of this meeting extends beyond deciding whether to hike rates; it lies in explaining the rationale for pausing while preserving necessary policy flexibility. If Warsh sends stronger inflation warnings, market expectations for a December hike could strengthen further; if he emphasizes patient observation of data, recent tightening bets may cool. Regardless, inflation trends will ultimately dictate the policy path.

Long Bets in U.S. Treasuries Intensify as Hawkish Signals from Warsh Could Reverse Yield Dip Trades

If the Fed takes a harder line at this week's monetary policy meeting, the long bets recently accumulated in the U.S. Treasury market could face a sharp reversal.

If Warsh sends hawkish signals on key issues like inflation, markets may reassess where the terminal rate will settle, triggering a painful wave of liquidation. Previously, some traders bet on continued safe-haven flows into Treasuries, building long positions anticipating declining yields and rising bond prices.

Citi strategist David Bieber noted that the most visible shift ahead of the FOMC meeting is investors turning tactically long in both U.S. Treasuries and European bonds. He pointed out that traders are chasing bond rallies through long positioning, even though the market remains net short from an aggregate structural standpoint.

Open interest data from CME Group shows traders have been trimming Treasury shorts over the past week while betting on the continuation of the prior rally. Underpinning this strength were concerns about the sustainability of AI-driven trading and downward pressure on the French government bond market.

Last Friday saw massive liquidations in the Treasury futures market, heavily concentrated in contracts tied to the 10-year note. The day prior, the Treasury market had just logged its best trading session in over two years, yet the 10-year contracts saw a surge in new risk exposure, with trading characteristics consistent with short covering.

JPMorgan's weekly survey also indicated that net long positioning in the market has climbed to its highest level since early September.

Ed Al-Hussainy, Portfolio Manager at Columbia Threadneedle, stated that the key factor determining whether the market can maintain its current pricing moving forward is the Fed's policy guidance.

This means that even if no rate hike materializes at this meeting, Warsh's commentary on future policy could still alter market trading dynamics. Should the Fed clearly signal readiness to tighten further, traders may need to reevaluate their bond long positions, leaving recently established bullish trades vulnerable to forced liquidation.

Meanwhile, options traders are actively hedging portfolio risks to guard against further yield declines and continued bond price appreciation. This demand has driven up the cost of related hedging options, which rose last week to their highest level since March.

Many traders are buying various call option structures for protection, with some strategies betting that the 10-year Treasury yield will fall further to around 4.6% over the coming weeks.

Sentiment skew in the options market has also shifted markedly, with pricing leaning heavily toward call options. In other words, compared to hedging against rising yields, traders are now willing to pay higher premiums to protect against further yield declines.

This positioning shift reflects lingering optimism for a Treasury rebound but also implies increased vulnerability to policy shocks. If Warsh emphasizes persistent inflationary pressures and the ongoing need for hikes, investors could swiftly exit long positions, weighing on bond prices and pushing yields back up; conversely, without reinforced tightening expectations, recent bullish trades may find continued support.

Thus, this week's Fed meeting does more than determine whether short-term rates will adjust; it could serve as a critical juncture for repricing positions in the Treasury market. The real danger is that long bets have already swelled significantly. Should policy guidance diverge from market expectations, the very trading flows that previously drove bond prices higher could quickly transform into pressure for accelerated liquidation.