The "most uncertain" in years, will tonight's Fed deliver a "shock"?

By Zhao Ying, WallstreetCN

Tonight's Federal Reserve decision is most likely to remain "on hold," but what the market is truly worried about is not the baseline scenario, but a rare unexpected rate hike, or a pause with wording hawkish enough.

At 2:00 AM on July 30, Beijing time, the Federal Reserve will announce the latest interest rate decision. This meeting has no dot plot or economic forecast updates, and the federal funds rate target range is expected to remain at 3.50%-3.75%. According to a Reuters survey, all 104 surveyed forecasters expect rates to remain unchanged. However, the money market still gives about a 32% probability of a rate hike this week and prices in about 42 basis points of tightening within the year, making tonight the meeting with the strongest "uncertainty" in recent years.

Uncertainty stems from the tug-of-war between two forces. June CPI was comprehensively below expectations, non-farm employment was weaker than expected, and oil prices fell before the meeting, all providing space for the Federal Reserve to continue waiting. However, inflation remains above target, the Middle East situation and oil prices are volatile, some Federal Reserve officials have recently made hawkish statements, and Chair Wash has not yet formed a clear policy record, making it difficult for the market to completely rule out the risk of a rate hike.

Jonathan Pingle, Chief U.S. Economist at UBS, stated that the level of uncertainty he feels about the upcoming Federal Reserve decision is the highest in 20 years—the last time there was a similar feeling was when Bernanke just took over as Federal Reserve Chair. "Wash will dominate policy direction in the next few meetings, and we know almost nothing about how he views monetary policy."

For investors, risks are concentrated in the immediate reaction of short-end rates, the U.S. dollar, and U.S. stocks. According to JPMorgan Market Intel calculations, if the Federal Reserve unexpectedly hikes rates by 25 basis points, the S&P 500 Index may fall 1.5%-2%; if rates hike by 50 basis points, the decline could expand to 2%-4%. Even if rates remain unchanged, as long as the statement and press conference are hawkish, it may limit the rebound of risk assets.

Market Consensus is a Pause, but Pricing is Not Calm

From a traditional forecasting perspective, this decision seems to have no suspense. According to a Reuters survey, all 104 economists expect the Federal Reserve to keep rates unchanged. Of these, 78 expect no rate adjustments for the rest of the year, and only 6 expect a rate cut.

But the same survey shows that 66% of respondents believe the possibility of a rate hike this year is "high," which is significantly different from the mainstream judgment of "low" in June. Market pricing also shows that investors are paying for tail risks of a rate hike. Traders currently not only give about a 30% probability of a rate hike this week but also fully price in a 25 basis point hike before September, and price in a hike magnitude of close to 50 basis points before March next year.

Goldman Sachs believes that this pricing means the outcome of this meeting is "exceptionally uncertain." If the Federal Reserve hikes rates, it belongs to rare unexpected actions historically; if rates are not hiked, the market will also quickly reevaluate the hike risks previously priced in. Ian Lyngen of BMO Capital Markets stated that since 2015, the average error of traders regarding the final interest rate decision the day before the Federal Reserve decision was only 2.4 basis points, and this time the market is more prone to a more violent immediate reaction than usual.

Data Supports Waiting, but Inflation Risks Remain

Reasons supporting a Federal Reserve pause mainly come from the latest data. June CPI was lower than expected, weakening the rate hike bets triggered by Waller's previously hawkish statements. Waller once stated that if June core CPI was hot, a recent rate hike should be considered; if data was cold, he still needed to see more similar readings before viewing it as a clear signal.

The labor market has also given the Federal Reserve more time to observe. June non-farm employment was weaker than expected, previous values were revised down, with a net revision of a decrease of 74,000 over two months, previously an increase of 93,000. Although the unemployment rate fell slightly, data indicates this may mainly stem from a decline in the overall labor force participation rate.

Oil prices are also a key variable. The conflict between the U.S. and Iran saw new escalation after the last meeting, relevant memorandums of understanding were violated, and both sides resumed strikes. However, over the weekend before the meeting, strikes paused, geopolitical risk premiums fell, and oil prices fell accordingly, which helps ease inflation expectations. Federal Reserve officials previously also reminded that one should not respond too quickly to supply shocks that may be only temporary.

The problem is that underlying inflation remains significantly above target. Morgan Stanley pointed out that upside risks include persistently high oil prices, a more hawkish Federal Reserve reaction function, and AI-driven investment pushing up the neutral interest rate. Goldman Sachs also believes that the combined impact of tariffs, war, and AI statistical errors on monthly inflation may weaken in the future, but uncertainty remains high; once inflation improvement interrupts, discussions within the Federal Reserve about rate hikes will heat up again.

Communication in the Wash Era is Itself a Risk

The last FOMC meeting presided over by Wash was also his first meeting. At that time, the statement was significantly shortened, forward guidance language was deleted, and the commitment of the committee to bring inflation back to the 2% target was strengthened. This means that even if there are only subtle wording changes this time, they will be amplified and interpreted by the market.

Morgan Stanley expects that this statement will most likely remain unchanged, including reiterating the "ample reserves" policy, describing economic activity as still "expanding at a robust pace" under high uncertainty, the unemployment rate "changing little," and inflation still "elevated." Since there is no Summary of Economic Projections this month, policymakers also have no need to reset market expectations through the dot plot.

The press conference may be more important. Wash is expected to be asked about the impact of the Middle East conflict on inflation, the newly announced Chair working groups, and whether the latest data will advance the policy action timeline. Goldman Sachs expects that Wash will not give clear policy signals, possibly emphasizing that all options remain open and future decisions depend on data.

Credit Agricole believes that the Federal Reserve is entering a new stage with more limited forward guidance, which will turn more meetings into true "live meetings." The bank expects that the Federal Reserve will still remain on hold this time and believes that data since the last meeting has at least bought time for continuing the pause. Regarding the five working groups newly established by Wash, Credit Agricole does not expect significant updates in the near term; relevant recommendations may not be completed until close to the end of the year, which also means balance sheet policy is unlikely to change temporarily.

Divergence Expands, Pause May Also Accompany Dissent, Watch for Dissenting Votes

Divergence within the Federal Reserve is the core of this meeting's uncertainty. In the June forecasts, 9 out of 18 participants who submitted forecasts expected at least one rate hike this year. Since then, statements from multiple officials show that if the disinflation process stalls, they are willing to consider further tightening.

Both Waller and Cook stated that if the disinflation process stalls, they may consider tightening policy. The speeches of 2026 voters Logan and Hammack were more hawkish. Logan argued that the policy rate should be moderately higher to better balance prospects and risks, and believes that some restrictive policy is still needed to help inflation return to target. Hammack directly stated that the Federal Reserve may need to consider a rate hike.

Therefore, even if interest rates remain unchanged, dissenting votes may occur. Based on recent comments alone, if the Federal Reserve chooses to pause, there may be 2 to 4 dissenting votes in favor of a rate hike. Goldman Sachs expects that this statement may acknowledge the upside inflation risks brought by geopolitical conflicts, and there may be at least one committee member voting in favor of a rate hike.

Bank of America analyst Mark Cabana expects the Federal Reserve to keep rates unchanged on Wednesday, but it may attract opposition from regional Fed presidents such as Lorie Logan and Beth Hammack. He also stated that if the market does not rule out rate hike risks, strategists will not rule them out either.

Few Institutions Bet on Rate Hike "Scare"

Although the mainstream view is still a pause, some institutions are clearly betting on an unexpected rate hike. Citadel Securities has become a significant outlier; its Head of Macro Strategy Frank Flight changed the baseline scenario to a 25 basis point rate hike this week. He believes this will strengthen Wash's credibility in fighting inflation and "clearly end the forward guidance era."

PGIM Global Head of Bonds and Chief Investment Strategist Robert Tipp also stated that the market may have underestimated the probability of action on Wednesday. He believes that Wash has actually set the stage for a rate hike; if the decision is postponed now, it may increase the probability of a 50 basis point rate hike in September.

Wrightson ICAP Chief Economist Lou Crandall stated that the Federal Reserve has no sufficient reason not to hike rates. Bond market veteran Harley Bassman even argued that the Federal Reserve should hike rates by 50 basis points at once to strengthen anti-inflation credibility.

However, Goldman Sachs still believes that most voters are unlikely to push for a rate hike this week after June inflation data was soft. The bank also pointed out that the Federal Reserve has historically avoided creating unexpected rate hikes at meetings, especially at meetings without a Summary of Economic Projections; officials may be more worried about the market overinterpreting their intentions.

Asset Reaction: Rate Hike is the Biggest Shock, Hawkish Pause is Not Easy Either

JPMorgan Market Intel lists "hawkish pause" as the baseline scenario, with a probability of 50%. In this scenario, the S&P 500 Index may rise 0.25% to fall 0.50%. The logic is that the Federal Reserve will pause because the labor market and growth still have resilience, but will continue to emphasize vigilance against inflation.

If rates unexpectedly hike by 25 basis points, JPMorgan expects the S&P 500 Index to fall 1.5%-2%, and the Nasdaq 100 Index decline may be larger. If rates hike by 50 basis points, the S&P 500 Index may fall 2%-4%. If it is a "dovish pause," meaning rates remain unchanged and communication is dovish, then the S&P 500 Index may rise 0.50%-1%. In terms of the options market, options expiring on July 29 price in about 0.8% S&P 500 volatility, lower than the recent CPI event pricing of about 1.1%.

In terms of foreign exchange, the Goldman Sachs FX team believes that if the Federal Reserve pauses, the U.S. dollar may show tactical weakness, but as long as energy prices remain high, this weakness may be relatively brief. In the medium term, if the Federal Reserve keeps rates unchanged within the year as expected by the bank's economists, it will constitute mild but controllable pressure on the U.S. dollar against G10 currencies.

The focus of the interest rate market is on the front end. The Goldman Sachs Rates Trading Desk believes that the market may misinterpret "lack of forward guidance" as deliberate ambiguity. The trading desk tends to believe that if the Federal Reserve Board does not support a rate hike, hawkish voters do not have enough votes to push for action this week. But if there is a pause in July, Wash may still give a hawkish pause and pave the way for a September rate hike.

In terms of commodities, the Goldman Sachs Crude Oil Trading Desk stated that the crude oil risk premium is fading quickly, because the U.S. and Iran formed a de facto ceasefire over the weekend, and negotiations to reopen the Strait of Hormuz are advancing. But upside risks have not disappeared; if attacks on Saudi oil facilities or production continue, oil prices may rise again. Gold has fluctuated within a range of about $250 over the past two months; the trading desk maintains a long-term bullish view but tends to trade tactically around news events.

This means that the key tonight is not just whether interest rates change, but how Wash explains "unchanged" or "changed." Against the background that the market has already paid for rate hike risks, while economists almost unanimously expect a pause, whichever side the Federal Reserve chooses may bring a significant shock to the market.