The Federal Reserve's decision to hold rates steady has been overshadowed by a market upheaval triggered by a press conference, which is now eroding investor confidence in its policy framework.
The Fed maintained its interest rate at the July Federal Open Market Committee meeting, but it was not the decision itself that captivated the market, but rather the statements made by Chair Walsh during the press conference. Rich Privorotsky, head of Goldman Sachs' trading desk, pointed out that Walsh failed to articulate a clear reaction function when addressing the trade-off between inflation and employment. This has sharply increased market uncertainty regarding the logic of Fed policy. Subsequently, the 30-year Treasury yield surged to new highs, causing a significant steepening of the yield curve.
Goldman Sachs warns this situation could prove counterproductive: by eliminating forward guidance while simultaneously obscuring its policy framework, the Fed risks further damaging its credibility rather than repairing it. More critically, the uncontrolled rise in long-term yields might compel the Fed to intervene again. Unless economic data clearly weakens before September, the market could force the Fed to raise rates once more to re-anchor long-term yields and restore its credibility.
Press Conference Becomes the Focal Point, Missing Reaction Function Sparks Doubt
According to Goldman Sachs' Rich Privorotsky, since taking the helm, Chair Walsh's primary objective has been to rebuild the Fed's credibility, which has been eroded after years of failing to meet its 2% inflation target, by eliminating forward guidance. However, removing guidance does not equate to avoiding transparency in the policy framework.
During the press conference, when pressed on how the Fed would balance inflation and employment, Walsh failed to provide a clear policy reaction function. When questioned about the basis for judging inflation, he stated the committee reviews a broad range of indicators but did not specify which ones carry the most weight or how they are weighted.
Rich Privorotsky noted that if the Fed removes forward guidance while simultaneously obscuring its policy methodology, the outcome for its credibility may be the opposite of its intention—not an improvement, but a deterioration.
Long-Term Yields Lose Anchor, Potentially Forcing Another Rate Hike
The market's confusion over the Fed's reaction function is directly reflected in the sharp volatility of long-term yields. The 30-year Treasury yield broke to new highs following the FOMC meeting, and the yield curve steepened notably, indicating heightened market concerns over long-term inflation and the fiscal outlook.
Goldman Sachs believes this trend has significant policy implications. Unless economic data shows a clear and broad-based weakening before September, the market may effectively "demand" that the Fed raise rates again to re-anchor long-term yields and restore policy credibility. The combination of low short-term rates and high long-term yields is particularly unfavorable for small-cap stocks and other long-duration assets.
Global Fiscal Expansion Adds to Long-End Pressure
The concern over long-term yields is not an isolated issue but is embedded within a broader global fiscal context. Goldman Sachs points out that in Japan, Takaichi is pushing for a reduction in the consumption tax; in the UK, policy discussions have shifted from "whether to increase defense spending" to "how to pay for it." Fiscal deficits across developed markets continue to widen, showing no signs of normalization.
Since the onset of the COVID-19 pandemic, the fiscal positions of major economies have moved in only one direction and have never normalized. This structural characteristic means that term premiums will remain elevated, inflation will be stickier, and nominal interest rates will stay at structurally high levels for a longer period.
Risk Assets Under Pressure, Market Deleveraging Continues
On the market front, Goldman Sachs paints a cautionary picture. Stocks are being sold off, the dollar is weakening, and risk assets are under broad pressure, with skepticism about the Fed's reaction function being a key driver.
Simultaneously, the market is undergoing a sharp deleveraging process. Goldman Sachs notes that the current drawdown in momentum strategies is more than 2.5 standard deviations below the 20-day average, a speed of deleveraging nearly unparalleled since the COVID-19 era. However, the nature of the two periods differs: during the pandemic, it was forced selling due to market dysfunction; this time, it appears to be a proactive unwinding following excessive concentrated positioning and high leverage accumulation.
Historical data suggests that from similar oversold levels, forward-looking returns over the next 15 years tend to be flat to positive. But Goldman Sachs argues that for a recovery with a better Sharpe ratio, the key is for realized volatility to converge relative to the S&P 500. Until then, momentum strategies are likely to experience choppier, more range-bound trading rather than explosive rebounds.
On the fundamental side, Goldman Sachs believes corporate earnings still support related trades, but the market's pricing logic is shifting. Investors are increasingly less willing to pay for AI capital expenditure alone and are instead more inclined to reward companies that can demonstrate AI monetization. Goldman Sachs believes this distinction will become increasingly critical in the upcoming earnings season.
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