According to Robert Ross, founder of TikStocks, the market's assessment of the Federal Reserve's interest rate path may contain a systematic bias.
Institutions like Bank of America predict the Fed could implement up to three rate hikes by 2026, with a market consensus leaning towards increases of 25 basis points each in September, October, and December.
However, the bond market is telling a different story. Following last week's report showing the US core PCE index rose 3.4% year-over-year in May, a three-year high, the yield on the highly rate-sensitive 2-year US Treasury note fell instead of rising. This suggests investors believe the worst inflation fears are already fully priced in.
The core of this divergence lies in the potential for the new Fed Chair, Wash, to adopt a different framework for assessing inflation than the market's mainstream view. If the market has misinterpreted the Fed's policy stance, significant revaluation opportunities may emerge for rate-sensitive sectors such as real estate, utilities, and technology.
Wash's Preferred Inflation Gauge: May Trimmed-Mean PCE at Just 2.4%
The traditional core PCE excludes food and energy but can still be skewed by extreme price movements in a few categories. The Dallas Fed's "trimmed-mean" PCE goes further by removing the most extreme price changes at both ends of the spectrum each month, aiming to provide policymakers with a purer measure of underlying inflation.
The current divergence between these two measures is significant: the May PCE was 4.1% year-over-year, while the trimmed-mean PCE was only 2.4%.
During his Senate confirmation hearing this spring, Chair Wash explicitly stated his preference for using the trimmed-mean PCE as an inflation reference benchmark over the core PCE typically tracked by the market.
This implies that, measured by Wash's preferred metric, the current US inflation situation is far less severe than the headline data suggests. The market's expectation of a hawkish policy stance from him may be overestimated.
Dovish Fed Official Remarks Undermine Case for Hikes
Public statements from several Federal Reserve voting members also contrast with the market's rate hike expectations.
New York Fed President John Williams stated he expects inflation to "gradually come down" over the next few quarters and believes current monetary policy is well-positioned to achieve that goal.
St. Louis Fed President Christopher Waller said last month that he is "prepared to be patient in maintaining the current restrictive stance." Notably, when Waller made these comments, international crude oil prices were around $96 per barrel; current prices have fallen to about $70 per barrel, a change that would further dampen inflationary pressures.
Overall, if Chair Wash shifts the Fed's policy reference framework from core PCE to trimmed-mean PCE, the inflation picture would immediately appear much milder. Combined with declining inflation expectations, a strong US dollar, and a policy rate that remains restrictive compared to most developed economies, the argument for initiating a new cycle of rate hikes is becoming increasingly untenable.
Fading Hike Expectations Could Trigger Sector Reassessment
This does not mean rate cuts are imminent. However, for the current US equity market, this shift in logic could represent an overlooked potential upside catalyst.
Current market concerns about rate hikes are partially baked into valuations, particularly suppressing sectors highly sensitive to interest rates like real estate, utilities, and technology. Once the market realizes the anticipated hikes are not materializing, this risk premium could be gradually repriced.
In other words, if the expectation for further tightening proves incorrect, sectors previously weighed down by interest rate anxiety could instead become leading forces in the market's next phase of gains.
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