CICC: It is expected that Walsh will restate the risk of inflation and retain the option to raise interest rates to rebuild its credibility

The Zhitong Finance App learned that CICC released a research report saying that the focus of the market this week was the Jackson Hole Conference and Walsh's speech. Earlier, Walsh's “let the market raise interest rates for the Federal Reserve” failed to ease concerns about inflation. Combined with the failure of the Treasury Department's intervention and damage to policy credibility, US bond yields continued to rise. It is expected that Walsh will reaffirm the risk of inflation and retain the option to raise interest rates to rebuild his credibility, but he will also continue to insist on long-term propositions such as reducing central bank intervention and reducing the frequency of communication.

CICC believes that Walsh has not abandoned the policy concept of “downsizing+interest rate cutting,” but the premise on which it was founded is misplaced with the current reality, and needs to be coordinated and expressed more clearly. If Walsh can show sufficient policy flexibility, market concerns about US bonds are expected to partially ease, and the US dollar will be supported; conversely, trust will continue to be lost, long-term US bond yields will continue to rise, and the dollar will be under pressure.

CICC's main views are as follows:

The focus of the global market this week is undoubtedly the Jackson Hole central bank governor's annual meeting, particularly the speech that Federal Reserve Chairman Walsh will deliver on Friday. The reason this conference has received special attention is because in the past month, the credibility of US monetary policy and fiscal policy has been questioned by the market, and investors are eager to hear more clear policy signals from Walsh.

Looking back at the FOMC meeting in July, the Federal Reserve chose to keep interest rates unchanged. At the press conference, Walsh put forward the statement “let the market raise interest rates for the Federal Reserve.” In an earlier report, CICC pointed out that in a context where US inflation has been above the 2% target for five consecutive years, this statement not only did not calm market concerns about inflation; on the contrary, it raised concerns that the Fed's determination to fight inflation was not firm enough, which in turn would increase the volatility of the bond market and spill over into the stock market.

Since then, market trends have confirmed this judgment: in August, US bond yields continued to rise, the 10-year US bond maturity premium increased markedly, and the yield curve steepened (Chart 1). Admittedly, there are multiple factors behind the rise in term premiums — Middle Eastern geopolitics are driving up oil prices, the scale of AI-related companies' debt issuance has surged, and the pressure on US government debt has raised concerns, but Walsh's failure to win market trust before is also a part that cannot be ignored.

After the yield increased, the Ministry of Finance immediately announced an increase in the scale of bond repurchases in an attempt to intervene. On the same day, the 30-year US Treasury yield declined by about 10 basis points, but the yield rose again the next day. Immediately after that, the US S&P PMI data for August hit a four-year high. Combined with rising oil prices, the yield was further boosted, and the effects of the Treasury Department's intervention were completely offset. The market generally believes that this intervention not only had no real effect; on the contrary, it may further damage the credibility of the policy.

It is in this context that Walsh's speech this Friday is critical. According to CICC, his most important task this time is to send a clear signal to the market and rebuild the Federal Reserve's credibility. To this end, he may need to pass on several aspects of information: first, to reaffirm that the risk of inflation has not been eliminated; second, to emphasize that interest rate instruments are still the core means of dealing with inflation; and third, to indicate that once inflation data is too high, the Federal Reserve will further tighten its policy.

What needs to be clarified is that these statements are not tantamount to forecasting interest rate hikes in advance; rather, they are more like an attitude of “not refusing to raise interest rates”. This is not a forward-looking guide, but rather an “option.” In fact, this is the attitude the bond market wants to see the most — the Federal Reserve is willing to act when the risk of inflation rises again.

This attitude is also generally in line with the current position of most officials within the Federal Reserve. The latest revealed minutes of the July FOMC meeting show that several officials advocated raising interest rates in July, while more officials believe that if inflation does not continue to fall, it is necessary to further tighten the currency in the future. This means that there is a strong consensus within the Federal Reserve on continuing to maintain a tight monetary policy. As chairman, Walsh is also responsible for clearly communicating this consensus.

At the same time, CICC expects that Walsh will continue to adhere to its consistent policy philosophy and continue to advocate reducing the Federal Reserve's intervention in the market. For example, it provides a theoretical basis for abolishing forward-looking guidelines and reducing the frequency of communication, paving the way for canceling bitmaps in the future and reducing the number of FOMC meetings from 8 to 6 times a year; he may also continue to stick to the direction of contraction, draw the boundaries between monetary and fiscal policies, and emphasize the influence of AI on economic structure and statistics, and argue that monetary policy should adapt to the new macro and technological environment.

According to CICC, Walsh's policy philosophy of “downsizing+interest rate cutting” itself has not wavered, but the premise of this concept is misplaced with the current reality. Walsh's logic is based on the judgment that AI can increase productivity and thus reduce inflation. Looking at the long term, this judgment is not necessarily wrong, but the problem is that it takes time for AI investment to be converted into productivity, yet the inflationary pressure brought about by the current expansion of capital expenditure and rising oil prices is occurring. There is a clear time gap between ideals and reality. Therefore, what really tests Walsh this week is whether he can maintain sufficient flexibility in short-term reality while adhering to long-term ideas, and clearly explain this misalignment between the long term and the short term.

CICC believes that if Walsh can show this flexibility, the market's trust in the Federal Reserve will increase: 2-year US bond yields may rise briefly, but 10-30 year yields are expected to decline, and the yield curve will flatten. The stock market may recover in the short term, but it will benefit in the medium term, and the policy uncertainty premium is expected to decrease. The dollar is expected to be supported, while gold is likely to be under pressure.

Conversely, if Walsh chooses to ignore short-term issues and stick to his long-term proposition, the market's skepticism about the Federal Reserve will further deepen, and the logic of “debasement trade (debasement trade)” may continue. At that time, 10-30 year US bond yields may continue to rise, dollar credit will also suffer greater losses, and gold may continue to rise.