U.S. inflation data unexpectedly cooled, combined with softening employment and consumer spending, causing a sharp retreat in market bets on a Federal Reserve rate hike in September this week. However, abnormal signals in the long end of the bond market, surging oil prices, and persistent hawkish official stances are challenging this "pause narrative." The probability of a September rate hike has plummeted from 75% in late July to around 25%, driving global stocks higher for a third consecutive week, with major U.S. indices holding near record highs.
Strong earnings reports from AI infrastructure-related companies have provided additional support for tech stocks, allowing equity markets to temporarily ignore the oil shock and warnings from the bond market's long end. Yet, the Iran/Hormuz Strait crisis pushed Brent crude oil up nearly 6% over the week, approaching $90 per barrel. The yield on the 30-year U.S. Treasury auction hit its highest level in 25 years. While stock markets cheer a potential "Fed pivot," the long end of the bond market is pricing in inflation and fiscal deficits. These two competing logics, each valid in its own right, represent perhaps the most critical trading proposition for the second half of the year.
Inflation Cools, September Rate Hike Expectations Collapse
The primary macro driver this week came from a series of soft U.S. data points:
The July CPI rose only about 0.1% month-over-month and roughly 3.4% year-over-year, with core inflationary pressures continuing to moderate gently. The July PPI was flat month-over-month, below expectations. July retail sales fell 0.6% month-over-month, marking the largest single-month decline in over a year and significantly missing expectations for a modest increase, dragged down by autos, gas prices, and various seasonal factors. Combined with the previously released nonfarm payrolls data (a decline of 23,000 jobs, with downward revisions), this collection of soft data has completely dismantled market expectations for a near-term Fed rate hike, erasing all the hawkish premium accumulated since Trump's nominee took over as Fed Chair.
Evercore ISI economist Marco Casiraghi believes the combination of CPI and PPI data supports holding rates steady in September, but the option for a hike is not entirely closed, noting "risks remain that could push the committee more towards hiking." Gregory Daco, chief economist at EY-Parthenon, expressed a more definitive optimistic view, arguing that the peak of oil-driven inflation linked to the Iran conflict "has likely passed," supporting the Fed's patience and forecasting the central bank will hold rates steady for the entire year. Stephen Brown, chief North America economist at Capital Economics, estimates the July core PCE rose only 0.16% month-over-month. If correct, "a September rate hike – as we previously forecast – now seems unlikely." However, hawkish voices have not been silenced. Diane Swonk, chief economist at KPMG, warned that the core PCE year-over-year rate might still be sticky around 3.3%. Swonk stated: "The modest CPI does not take a September rate hike off the table. This number could not only strengthen the resolve of the hawks but also build more internal support within the Fed's leadership for a hike." Cleveland Fed President Beth Hammack, following the CPI report, reiterated her view that the Fed needs to raise rates immediately to curb inflation. Hammack had previously voted for a rate hike at the FOMC meeting.
The Long End of the Bond Market Sends a Starkly Different Signal
The most important, yet perhaps most overlooked, signal in the market this week came from the long end of U.S. Treasuries. Despite the soft inflation data and a sharp drop in rate hike expectations, the yield on the 30-year Treasury auction hit a 25-year high this week, while the 10-year auction yield also remained in historically high territory. The 30-year yield rose more than 6 basis points over the week, touching its highest level in nearly 19 years, while the 2-year yield fell to about a one-month low. The 2-year/30-year yield spread widened significantly, resulting in a substantial steepening of the yield curve. This divergence reveals two entirely different sets of pricing logic: the short end trades on the expectation that the Fed will soon stop hiking, while the long end prices in the massive fiscal deficit, persistent inflation uncertainty, substantial Treasury supply, and doubts about the Fed's credibility, demanding a higher risk premium for duration. As analysts point out, the market may believe the Fed has finished raising rates. But this does not equate to the market believing inflation has been fully conquered. This divergence could evolve into one of the most decisive trading themes of the second half of the year.
Jackson Hole to Serve as a Key Litmus Test
When Fed officials gather in Jackson Hole in two weeks, it will mark the first public address by the new Fed Chair since taking office. The market will look for clear signals regarding the economic outlook and the monetary policy path. Historically, Fed chairs have used this forum to lay the groundwork for September policy actions or announce major framework changes. Former Atlanta Fed President Dennis Lockhart, in an interview with Yahoo Finance, stated: "This is a pretty tense moment – the economy is full of uncertainty, the market reacted strongly to the July press conference, there are divisions within the committee, and questions about the Chair's initial performance haven't faded." Lockhart noted there is a view that as tariff effects fade and the Hormuz issue is resolved, inflation will naturally fall back to the 2% target, but "that's a gamble. I think some officials are reasonably cautious and even skeptical about using that as a basis for decision-making." In his view, one or two months of soft inflation data is not enough to change the Fed's basic narrative. Inflation has been above target for over five years, the labor market remains near full employment, and it's still up for debate whether the job market is truly weakening. The August 26 PCE data will be released just before the Jackson Hole symposium, and August CPI data, often volatile, won't be available until a few days before the September meeting. This means the decision on whether to hike in September will ultimately be purely data-dependent, and any unexpected number could once again reverse current market pricing.
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