From a market standpoint, a potential rate hike within the year is already largely priced in. The Federal Reserve has held rates steady five times in a row since December, but the debate over whether it will resume tightening in September is widening. On July 29, the Federal Open Market Committee (FOMC) voted 9-3 to keep the federal funds rate unchanged, with three dissenting members favoring a 25-basis-point hike. This marks the first time in a decade that three committee members have dissented on the same rate decision.
This divergence did not emerge suddenly. Two weeks prior, Dallas Fed President Lorie Logan, one of the dissenters, laid out the case for a "modest rate hike" in a public speech, arguing it would better balance the risks to the Fed's dual mandate of maximum employment and price stability. Meanwhile, the two-year Treasury yield had already moved higher, interpreted by the market as fixed-income markets re-pricing a rate hike within the year.
However, inflation data points in the opposite direction. Data from the Bureau of Labor Statistics this month shows the Consumer Price Index (CPI) fell 0.42% month-over-month in June, the largest single-month decline since April 2020. The year-over-year increase also slowed to 3.5%, the first deceleration in five months.
Will the Fed actually raise rates this year? Could persistently high oil prices re-anchor long-term inflation expectations? In an interview with Yicai, Invesco Chief Global Market Strategist Brian Levitt said that while the probability of one more rate hike by year-end has increased, given that inflation expectations remain well-anchored at low levels, any move would be a "one-time" fine-tuning at the tail end of the tightening cycle. He also predicted the Fed will ultimately pivot to cutting rates in 2027.
Inflation and Oil Prices
Yicai: Do you expect the Fed to raise rates in September or keep them unchanged for the rest of the year?
Levitt: My personal hope is that the Fed holds rates steady, but the probability of a hike by year-end has indeed risen. If they do hike, given that our inflation expectations are manageable, I believe it would be a "one-time" event. The good news for market participants is that, from the market's perspective, this is already largely priced in. The two-year Treasury yield has already seen a significant reaction. More tellingly, at the start of the year, the market expected three rate cuts; now expectations have shifted to one or two hikes, yet credit spreads are performing well, value stocks are doing well, and small-cap stocks are also performing well. Despite the shift in expectations for the Fed, all of this, to me, is a very bullish signal for the market. If the Fed does hike again, I think it will be a one-time adjustment.
Yicai: Could persistently high oil prices evolve into long-term inflation, impacting the Fed's decisions?
Levitt: While oil prices have experienced some volatility, the price per barrel has remained in a relatively stable range overall since the end of March. There was a sharp increase at the onset of the conflict, followed by some fluctuations, but over the past three to four months, oil prices have generally been consolidating sideways. While this could put some pressure on consumption, the share of disposable income spent on gasoline is currently far below several historical highs. Therefore, I don't think oil prices will significantly drag on consumer spending, and I don't believe this will evolve into long-term inflation. Long-term inflation is typically driven by excessive demand and rapid wage growth, creating a demand-wage spiral. That is not the current reality in the US; the current oil price volatility is a supply-side shock that ultimately won't generate broad-based inflationary pressures. In fact, long-term inflation expectations remain very well-anchored. This suggests the Fed is not as far behind the curve as the market currently fears.
Yicai: Oil prices have been volatile recently but haven't returned to the $100 per barrel level, and shipping throughput through the Strait of Hormuz hasn't recovered. Does this mean the market has become desensitized to the risk of a blockade? What is your oil price forecast for the next 6 to 12 months?
Levitt: The market appears somewhat numb because there is an expectation that diplomatic negotiations will eventually reopen the Strait of Hormuz and restore shipping traffic. Although this expectation hasn't fully materialized, you can see that prices react quickly whenever the market anticipates a potential resolution. My forecast for oil prices is that they will be lower in six months than they are today, but that doesn't mean they will return to the $55 to $60 per barrel level seen at the start of the year. The logic behind this view is that current high oil prices will lead to a moderate slowdown in global economic activity, while parties will eventually reach an agreement to restore crude oil shipments through the Strait of Hormuz. Of course, if geopolitical conflicts escalate or broaden further, this forecast could face changes. However, historical experience suggests that after a sharp rally like the one seen in March, oil prices typically decline 12 months later, while stock markets move higher. The market's trajectory so far is still consistent with this historical pattern.
Still Overweight Non-US Assets?
Yicai: You mentioned that the market's fundamentals haven't materially changed, but the current interest rate environment is very different from what you expected in May. Does your previous recommendation to overweight non-US assets still hold? What would need to change for this allocation logic to reverse?
Levitt: The core question is whether this volatility is driven by a deterioration in fundamentals or by concerns at the narrative and sentiment level. I believe it is more of a narrative-driven concern. Earnings for AI-related companies remain strong, and US inflation expectations are still manageable, so I don't see a basis for a sustained, significant rise in interest rates. In fact, the current volatility actually creates an opportunity to buy US Treasuries. The logic for overweighting non-US assets typically requires two preconditions: a recovery in global economic activity and a weaker US dollar. This was our core thesis at the start of the year. However, the conflict in the Middle East has somewhat slowed this process, causing a moderate slowdown in global economic activity and delaying the pace of Fed rate cuts. Nevertheless, the strong performance in non-US markets earlier was largely driven by AI themes, rather than traditional global cyclical sectors. I believe the trade for a non-US cyclical recovery will eventually play out, and the dollar will weaken, but we first need to navigate this phase where the market broadly expects the Fed to maintain high rates or even hike.
Yicai: Gold prices have been oscillating around the $4,000 level for some time. What is your view on gold?
Levitt: Gold prices are closely correlated with real interest rates. Currently, inflation expectations are low, and nominal Treasury yields have risen, pushing real yields higher. When real yields are elevated, gold typically faces downward pressure. However, if the Fed doesn't need to hike as much as the market fears, and instead pivots to cutting rates as the economy slows, that would drive real yields lower, which would be positive for gold. Gold has shown remarkable resilience around the $4,000 level, and I expect prices to break further to the upside as the Fed shifts to a more accommodative monetary policy stance in 2027.
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