A research report suggests the Federal Reserve's stance this year may be more hawkish in rhetoric than in action. The more likely policy outcome could be banking deregulation to sustain the investment cycle and buy time for AI to enhance economic efficiency. The market may initiate a "behind-the-curve" trade once peak rate hike expectations are not met with actual tightening. This trade would center on the Fed's increased tolerance for inflation and economic recovery within a de facto accommodative monetary environment. Consequently, the US dollar could revert to the weaker trading range of the past year, and market style may shift accordingly. The outlook remains positive for real assets, upstream sectors, and technology outperforming within major asset classes. The report emphasizes the overarching theme of "national security" and the dual threads of "resource and energy self-sufficiency" and "productivity enhancement," recommending countries, asset classes, and industry sectors positioned upstream in the raw materials and AI supply chains.
Since June, markets have entered a phase of consecutive adjustments. On one hand, the US Dollar Index has broken above the upper bound of its one-year trading range. On the other hand, global equity indices that had been buoyed by AI optimism and were sensitive to US dollar liquidity have broadly retreated. Within the US stock market, a style rotation has occurred, with more defensive sectors gaining the upper hand. This series of adjustments has been primarily driven by the intensification of interest rate hike expectations and a marginal tightening of US dollar liquidity. While the new Fed Chair may adopt a hawkish posture initially to establish credibility, the fundamental economic and financing environment likely does not support actual rate hikes for the full year, resulting in a "hawkish in name, dovish in deed" monetary policy stance. Following this adjustment, the market may pivot to the "behind-the-curve" trade, potentially leading the dollar index back into a weaker range. Real assets, industrial sectors, and technology still hold expansion potential, and the potential boost from financial deregulation on traditional cyclical sectors warrants attention.
Liquidity: From Marginal Easing to Marginal Tightening
From December last year to May this year, influenced by the Federal Reserve's balance sheet expansion via the Reinvestment of Maturities Program, the Fed's narrow liquidity measure (bank reserves) gradually increased from a low of around $2.9 trillion. This marginally alleviated the liquidity strain triggered by Treasury issuance since last July. Short-term market funding pressures eased, as evidenced by the narrowing spread between the Secured Overnight Financing Rate and policy rates like the Interest on Reserve Balances and the Overnight Reverse Repo Rate.
However, as funding pressures improved, the pace of the Fed's balance sheet expansion slowed from approximately $40 billion per month in late April to about $10 billion per month currently. Concurrently, the marginal tightening effect of fiscal financing is strengthening. The outstanding US Treasury debt surpassed $39 trillion in May, with market expectations suggesting the debt ceiling (around $41 trillion) could be reached as early as next summer. In next year's debt ceiling negotiations, a potential scenario where the government faces default risk due to legislative delays in raising the limit could prompt early cash accumulation as a hedge, tightening reserves. Indeed, over recent quarters, the US Treasury has consistently raised its target balance for the Treasury General Account, absorbing liquidity and tightening reserves. The combined effect of slower balance sheet expansion and fiscal financing tightening ended the downward trend in the SOFR spread in June, reigniting funding pressure. This forms a crucial backdrop for the recent US dollar strength and market adjustment.
Rate Hike Expectations: Raised High, Likely Set Down Gently
The fermentation of rate hike expectations exacerbated the tightening liquidity situation, causing the US Dollar Index to surge rapidly in late June and break through resistance levels. However, looking ahead, the report reiterates that US economic fundamentals do not support an actual rate hike within the year. It is anticipated that the elevated rate hike expectations and the strong dollar will likely be "set down gently" in the coming months.
Firstly, underlying economic resilience is not solid. The lower segment of the K-shaped economy (consumption, real estate, small businesses) remains weak and cannot withstand rate hikes. US small businesses have experienced a slow recovery in this easing cycle, with weak hiring demand. The labor market appears frozen, with hiring and separation rates even below pre-pandemic levels. The Atlanta Fed's Wage Growth Tracker fell to 3.5% in May, and real wages have even declined.
Secondly, the current economic operation heavily depends on an accommodative financing environment. For the lower segment of the K-shaped economy, financing costs for consumer loans, auto loans, and small businesses are linked to policy rates. For the upper segment, the upturn in the investment cycle is extremely reliant on loose bank credit. Historically, once the Fed initiates a hiking cycle, bank credit conditions often shift from loose to tight.
Recent developments show that with progress in US-Iran negotiations pushing oil prices lower, inflation expectations have already begun to recede, a fact acknowledged by the Fed Chair in a July 1st speech. Meanwhile, a significant decline in the Weekly Economic Index since June suggests that as the rush-order demand related to geopolitical tensions subsides, the US economy's actual growth may not be as robust as market expectations. The Atlanta Fed has already revised down its estimate for Q2 annualized real GDP growth to 1.2%.
Market: From Adjustment to "Behind-the-Curve" Trade
The report reiterates the view of a rhetorically hawkish but practically dovish Fed this year. The more feasible policy action for the Chair this year is likely banking deregulation, aimed at maintaining the vitality of the investment cycle and buying time for AI to enhance economic efficiency. Before inflation data shows a substantive decline, rate hike expectations may continue to simmer. "Credibility-establishing" rhetoric from the Fed Chair and others about reaffirming Fed independence could remain key points that jangle market nerves, sustaining dollar strength and stimulating market adjustments in the short term.
However, the report also highlights that the market is poised to initiate the "behind-the-curve" trade once rate hike expectations peak without being followed by actual Fed tightening. This involves trading on the Fed's heightened tolerance for inflation and the economic recovery unfolding in an environment of de facto accommodative monetary policy. At that point, the US dollar could return to the weaker trading range of the past year, and market style may revert. The outlook continues to favor outperformance by real assets, upstream sectors, and technology within major asset classes. It emphasizes adhering to the major theme of "national security" and the two main threads of "resource and energy self-sufficiency" and "productivity enhancement," recommending exposure to countries, asset classes, and industry sectors positioned upstream in the raw materials and AI supply chains.
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