September Rate Hike: The Fed's Least Bad Choice?

The unexpectedly strong non-farm payroll data has pushed the probability of a rate hike by the Federal Reserve in September to 60%, leaving Fed Chair Waller in a dilemma of either "disappointing the market" or "disappointing Trump."

Written by: Zhao Ying, Wall Street Insights

The stronger-than-expected non-farm payroll data has raised the probability of a rate hike by the Federal Reserve in September to 60%, putting Fed Chair Waller in a dilemma of either "disappointing the market" or "disappointing Trump."

Shenwan Hongyuan Research pointed out in its latest report on September 8 that historical patterns indicate that once market expectations for a rate hike exceed 40%, a hike has never been missed; if this expectation is missed, the term premium may rise significantly, posing a "backlash" risk to the market.

The non-farm employment data released on September 4 showed an increase of 162,000 jobs in August, far exceeding the market expectation of 55,000, directly triggering a sharp repricing of the market's expectations for a rate hike by the Fed in September. Meanwhile, the rebound in oil prices and the stickiness of AI-related inflation suggest that the probability of a significant drop in the August CPI is only about 10.6%, indicating that the market's high expectations for rate hikes are unlikely to dissipate after the CPI data is released.

In this context, Shenwan Hongyuan believes that a rate hike in September may be the Fed's "least bad choice"—the cost of not raising rates could lead to a rise in term premiums and market backlash, while if a hike occurs without a significant upward revision of the rate hike path, the impact on the market would be relatively limited.

Strong Non-Farm Data Keeps Rate Hike Expectations High

After the release of the August non-farm data, the market's pricing for a rate hike by the Fed in September quickly heated up. On September 3, after a speech by Fed Governor Christopher Waller, the probability of a September rate hike briefly fell to 50%; however, following the non-farm data release, the probability rebounded to around 60%.

The August CPI data will be the last key variable before the September monetary policy meeting. Historical data shows that only significantly lower-than-expected CPI data can lead to a substantial downward revision of market rate hike expectations. According to Shenwan Hongyuan's statistics, since 2015, in cases of low inflation expectations, the average downward revision of market expectations for the next meeting on the day of CPI release has only been 6 percentage points; historically, there have only been 13 instances where the rate hike expectations were revised down by more than 10 percentage points on the day of CPI release, and only 3 of these occurred in contexts where inflation was flat or slightly exceeded expectations, all accompanied by external shocks such as pandemic impacts, unexpected dovish signals from Fed officials, or banking crises.

Currently, the August CPI faces dual pressures from energy and structural inflation. The escalation of the US-Iran conflict has led to disruptions in the Strait of Hormuz, causing oil prices to rise sharply, with the cracking spread in the US Bay Area reaching $67.9 per barrel; prices for AI-related services are also showing a structural upward trend. Based on 10,000 Monte Carlo simulations using four institutional forecasts, Shenwan Hongyuan found that the probability of a significantly lower-than-expected CPI is only about 10.6%.

Expectations Above 40% Have Never Been Missed; Missing Could Lead to Backlash in Term Premiums

Currently, there is significant internal disagreement within the Federal Reserve. After a 9 to 3 vote at the July monetary policy meeting, internal divisions have further intensified. Recent statements from Beth Hammack, Neel Kashkari, and Lorie Logan have been relatively hawkish, continuously calling for rate hikes; while Christopher Waller and John Williams have been more dovish; Waller himself indicated on August 28 that if core inflation does not improve significantly, "there is still work to be done," showing signs of a hawkish shift.

Historical data is of significant reference for Waller's decision-making. According to Shenwan Hongyuan's statistics, among the 92 Federal Open Market Committee meetings since 2015, whenever market expectations for a rate hike exceeded 40% in the 10 trading days leading up to the meeting, a hike has never been missed, with a total of 20 instances occurring as scheduled or exceeding expectations. There have only been 5 instances where expectations between 30% and 40% ultimately missed, occurring in September 2015, September 2016, May 2018, November 2018, and July 2026.

Among these 5 missed cases, the situations in 2015 and 2016 were accepted by the market due to global risks and weak economic data, but the cases in May 2018 and July 2026 are particularly concerning—these two instances were meetings at the beginning of Powell's and Waller's terms, respectively, where a missed rate hike expectation led to a significant rise in long-term term premiums: in the 10 trading days following the missed hikes, the 10-year term premium rose by 5.0 basis points and 6.2 basis points, respectively.

Trump's political pressure cannot be ignored either. As of September 3, Polymarket data shows a 51% probability of the Democrats taking control of the Senate, with both parties predicted to hold 50 seats, putting Trump under significant pressure from potential midterm election losses. However, Shenwan Hongyuan notes that historical data shows that since 1983, there have been 3 instances of rate hikes occurring in September during midterm election years or years when sitting presidents sought re-election, with frequencies not lower than in "non-politically sensitive years"; in 2018, Powell, who had just been nominated by Trump, also raised rates consecutively despite political pressure. Overall, market pressures may tilt Waller's balance towards a rate hike.

Limited Impact of Rate Hike; Key Is Whether Path Is Revised Upwards

If the September rate hike occurs as expected, historical patterns indicate that its impact on asset prices is relatively limited. According to Shenwan Hongyuan's analysis of asset performance following 51 rate hikes since 1990: US stocks typically show a pattern of short-term pullback and medium-term recovery, with cyclical stocks performing relatively weakly; the yield on 10-year US Treasuries tends to rise, but the term premium significantly declines.

The differentiation in asset trends post-rate hike mainly depends on two factors: whether the hike exceeds expectations and whether the forward path for rate hikes is revised upwards after the hike. Taking 10-year US Treasuries as an example, in cases where the rate hike exceeds expectations, the average yield over the next 20 trading days falls by 9 basis points; conversely, when the hike is less than expected, the yield rises by an average of 28 basis points. In cases where the forward rate hike path is clearly revised upwards, the yield on 10-year US Treasuries rises by an average of 35 basis points over the next 20 trading days; while when the rate hike path remains largely unchanged, the yield falls by an average of 5 basis points.

Shenwan Hongyuan believes that if the September rate hike slightly exceeds expectations, the market may view it as a relative prelude to rate hikes over the next year, which may not lead to a significant upward revision of the rate hike path. The reasoning is as follows: on one hand, the August non-farm data is significantly affected by seasonal adjustment factors, and considering the low hiring rate, low layoff rate, and low labor participation rate, the US labor market remains in a "weak balance"; on the other hand, wage growth has not shown a significant upward trend, and current inflation is more structural rather than widespread, raising doubts about the necessity of multiple consecutive rate hikes. If the dot plot guidance in September does not lead to a significant upward revision of the rate hike path, the impact of the rate hike on the market may be relatively limited, with limited impact on short-term US Treasury yields, and the term premium may even marginally decline.