Guolian Minsheng Securities: Market's expectations of interest rate hikes are too aggressive, making it difficult for the Federal Reserve to act.

Guolian Minsheng Securities released a research report stating that the current market's expectation of the Federal Reserve's interest rate hike within the year is rapidly increasing. However, the bank believes that the actual probability of a rate hike is low. Despite resurfacing inflation concerns and weakening US employment market indicators (new non-farm payroll additions close to 0, rising unemployment rate), the lack of key foundations for sustained inflation transmission from oil price increases include the following: increased US energy self-sufficiency on the supply side, weak economic conditions on the demand side, fiscal stimulus tapering, and the lack of a wage-inflation spiral mechanism. The bank points out that historical experience shows that the Federal Reserve typically initiates rate hikes with strong support from employment and stable inflation expectations, conditions which currently do not align. A rate hike could exacerbate the risk of economic "K-shaped" differentiation, impacting AI investments and middle to low-income groups, potentially leading trading focused on "stagflation" towards "recession". Guolian Minsheng Securities also added that multiple conditions need to align for a rate hike to resume within the year, including sustained high oil prices due to geopolitical tensions, fiscal expansion to boost demand transmission, and changes in the policy stance of the Federal Reserve leadership. However, achieving these conditions at present is challenging. The main perspectives of Guolian Minsheng Securities are as follows: In just a few weeks, market expectations for liquidity for the rest of the year have made a 180-degree turnaround. Amid continued tension in the Persian Gulf and sustained high international oil prices, inflation risks have increased again. Major central banks this month have generally held their policies steady, even signaling a hawkish stance, reversing the market's previous loose expectations. Currently, the risks of a return to a global tightening cycle have significantly increased, with liquidity tightening pressures becoming more apparent, and major asset classes, apart from crude oil and the US dollar, experiencing significant pullbacks. Similarly, the Federal Reserve is no exception. At the beginning of the year, the market generally expected two rate cuts from the US within the year, but with inflation concerns resurfacing, policy expectations have significantly shifted, with the market even beginning to price in the possibility of a rate hike. However, market expectations often have an inertia to linear extrapolation, leading to the possibility of back-and-forth corrections in the future. Just like the current rapid rise in rate hike expectations, once corrections occur, the market's potential for rapid reverse corrections may also be significant. So, is it possible for the Federal Reserve to raise rates again this year? We believe that the probability of this is low. The threshold for the Federal Reserve to resume rate hikes is high, and under multiple constraints, maintaining rates or even further rate cuts may be the policy bottom line. With economic weakness and hindered inflation transmission efficiency, the likelihood of further rate cuts within the year remains a possibility. Specifically, 1. Reflecting on history: How has the Federal Reserve approached rate hike cycles? Looking back at previous rate hike cycles, we can see that the Federal Reserve typically initiates rate hikes with the following typical characteristics from the dual goals of employment and inflation: 1) A continuously improving job market and tight labor supply and demand conditions often form important prerequisites for the Federal Reserve to start rate hikes. In past rate hike cycles since 1970, before initiating rate hikes, the US has typically had an average of around 200,000 new non-farm jobs added monthly, while the overall unemployment rate was in a downward trend. Strong job performance provided a solid fundamental support for the Federal Reserve to begin tightening monetary policy. 2) The level of inflation is an important consideration for raising rates, but inflation expectations are equally important, directly determining the urgency and extent of the Federal Reserve's tightening policy. The Federal Reserve does not always raise rates in response to a clear increase in inflation; even when inflation remains mild in the short term after the economy stabilizes, the Federal Reserve may raise rates on concerns about wage stickiness and potential future inflation rebounds. In times of significant supply shocks such as the oil crises of 1973 and 1977 and the major supply chain disruptions and energy price shocks in 2022, the Federal Reserve often responds with rate hikes that lag behind the rise in prices, with interest rate increases tending to run parallel or even lag slightly behind the rising inflation trend. Contrastingly, the current stage presents significant differences compared to the macro environment and historical rate hike cycles: On one hand, the US labor market has been showing sustained weakness, with a shaky foundation for job recovery. Currently, the US new non-farm payroll additions are staying close to 0, and the unemployment rate is trending upwards. In this context, if the Federal Reserve were to hastily initiate rate hikes, it would not only fail to provide policy support but could further impact the already fragile job market and exacerbate economic downward pressure. On the other hand, although there are short-term concerns about inflation, inflation expectations remain relatively stable. This is due, in part, to the recent increase in international oil prices, lacking key foundations for sustained inflation transmission from both the supply and demand sides. Comparing the petroleum crises of the 1970s and the two energy price shocks caused by tensions between Russia and Ukraine in 2022, the ability for inflation to continue spreading during those times was fundamentally supported by a special supply situation and strong demand stimulus policies - conditions that are not present currently. Specifically, the stagflation in the US during the 1970s was the result of supply shocks combined with inadequate policy measures, ultimately leading to a detachment of inflation expectations. Even before the oil crisis, signs of inflation vulnerability in the US were already evident. Operating under the Keynesian stimulus framework post-World War II for economic growth and full employment, the government implemented expansionary fiscal and monetary policies: on the one hand, the expansion of the "Great Society" welfare program significantly increased government spending, leading to a rise in the overall deficit ratio in the mid to late 1960s; on the other hand, the Federal Reserve maintained loose liquidity for an extended period, with rapid growth in the money supply driving total demand to overheat continuously. Inflation expectations rose steadily, and the Federal Reserve failed to tighten policies in time to curb it, displaying inadequate resistance to inflation during the subsequent anti-inflation process. In the end, a series of supply shocks in the 1970s led to a complete detachment of inflation expectations. Following the Middle East conflict that triggered the OPEC oil embargo, the severe shortage of international crude oil, coupled with the high dependence of the US at that time on imported oil, led to a direct increase in production costs across the entire US industry chain due to rising oil prices. Companies were forced to raise prices, becoming the core catalyst for a broad-based inflation surge. Additionally, with strong labor unions in the US at that time, wages were prone to rise but resistant to fall, further pushing up business costs and driving further increases in prices, forming a spiral of inflation. Conversely, the high inflation in the US in 2022 is more of a result of overheated demand and tight labor market conditions post-pandemic. While the Russia-Ukraine conflict triggered disruptions in global energy supply, the main driving force behind the current inflation peak lies in the massive fiscal and monetary stimulus policies introduced during the pandemic. The release of excess savings by households fueled a phase of excessive consumer demand, combined with a high labor market shortage (due to the sharp drop in labor participation rates during the pandemic) causing wages to increase rapidly. This rapid cost pressure spread throughout goods, services, and rental sectors, leading to an unparalleled broad-based high inflation not seen in almost forty years. Examining the trend of inflation structure also serves as a confirmation that the energy-driven inflation in the US had already quickly peaked and started to fall back by 2022, leading to weakness in the goods sector. However, core CPI sub-items such as housing only started to trend downwards by mid-2023, showing that the overheating of service demand due to fiscal stimulus was a significant factor for the sustained high inflation. Currently, both the ability of the supply side to resist shocks and the transmission power of the demand side present fundamental differences compared to previous cycles: On the supply side, the changing role of the US in the global energy supply structure fundamentally reduces the degree of transmission of oil price increases to inflation. On one hand, the shale oil revolution has increased US energy self-sufficiency and made it a net oil exporter, significantly enhancing its ability to resist disturbances in global energy supply, making it challenging to sustain an energy deficit; at the same time, revenue from oil exports can offset rising costs for businesses to some extent, restraining the impetus for price hikes. On the other hand, rapid adoption of new energies and continuous improvements in industrial efficiency have reduced the overall reliance of the US economy on crude oil, leading to a decline in the weight of energy sub-items in the CPI basket, mitigating the impact on overall inflation. Furthermore, the absence of a wage-inflation spiral mechanism is a crucial factor in curbing the continuous spread of inflation from the cost side. Currently, the US labor market is cooling down gradually, with job vacancies gradually decreasing. Coupled with the decreasing influence of labor unions and wage stickiness, a significant positive feedback loop between wages and inflation has not yet formed, effectively halting the spiral of cost pressures from escalating and significantly boosting prices across the board. On the demand side, the weak economic landscape makes it challenging for oil price increases to smoothly transmit downstream pressures. While the Federal Reserve has already started a cycle of rate cuts, policy rates are still significantly higher than neutral levels, indicating an overall tight monetary environment that continues to suppress durable goods consumption, investment, and the real estate market. Simultaneously, the high level of US government debt and significantly limited fiscal space point to a gradual reduction in large-scale demand stimulus policies, weakening the role of the fiscal side in supporting total demand. In the context of the US K-shaped economy, the current rise in oil prices lacks extensive support from broad-based demand and is unlikely to lead to sustained pressure for rising prices from the energy side. Especially under high-interest rates, core inflation sub-items such as housing remain in a trend of decline. This further weakens the upward momentum of overall inflation, providing crucial support on the demand side for stable inflation expectations. Reviewing history, it becomes apparent that since the major stagflation period of the 1970s, the secondary stimulus effect of oil price fluctuations on core inflation has significantly diminished, thanks to the energy structure transformation, enhanced discipline of the Fed, and flexible adjustments in the labor market. Especially in the absence of strong support from the demand side, oil price shocks are less likely to lead to sustained transmission of inflation. In the face of such supply shocks, the traditional policy logic of the Federal Reserve is often to wait before considering the interim rise in inflation, the weight on core inflation rates climbing steadily, or clear expectations of upward inflation surges, before triggering a rate hike. This method is primarily due to the uncertainty about the sustained transmission of supply side shocks and the potential economic downturn acting as a counterbalance against inflation rises. Considering the current scenario, and factors like the weak labor market indicators, as well as the effectiveness of inflation transmission, the US does not currently meet the conditions for a rate hike. Moreover, with the significant uncertainties in the Middle East geopolitical situation and unclear trends in international oil prices, coupled with potential policy reversals from the Trump administration, initiating rate hikes could lead to significant market expectations disorders and substantial financial market volatility, jeopardizing stable economic operations. 2. The Costs of Rate Hikes? Trading from "Stagflation" to "Recession" Apart from the strict conditions for rate hikes, the costs of such increases are also challenging for the US economy and the Trump administration to bear. In the background of a fragile US economy and financial markets (excluding AI), expedited rate hikes could significantly impact the economy negatively, potentially transitioning from the trading of "stagflation" - a period of persistent inflation, slow economic growth, and high unemployment - to a "recession." As we mentioned previously, the core issue currently facing the US economy is its "K-shaped" differentiation, especially in a midterm election year, which is fundamental for Trump to address. On one hand, keeping AI investments supportive to the economy, along with stock market increases boosting consumer spending, and on the other hand, maintaining the scale of fiscal expansion to "protect livelihoods." However, once rates begin to increase, the negative impacts on both these aspects become evident: Looking at AI investments, while the AI industry is still in its maturation phase, possibly not yet at the stage of creating asset bubbles, concerns about high valuations and rapid rises have been prevalent in the market. The overall vulnerability of the tech sector has significantly increased, making it highly sensitive to policy and liquidity changes. Once rate hikes are enforced, the market could adopt sustained negative expectations, leading to a rapid decline in risk appetite. This would not only prompt corrections in tech stocks (with the MAG7 representing over 30% of the total market value of the S&P 500), reducing household wealth effects significantly but could also directly inhibit investment and financing in the AI sector, as well as contracting capital expenditures. This logic is not unfounded. The historical experience from the technology and internet bubble of 2000 provides a strong warning: during liquidity tightening and rising rate cycles, high growth sectors with elevated valuations often bear the brunt. The prior valuation expansions driven by capital could unsustainably bolster existing elevated valuations; when coupled with lower-than-expected profit realization, this can easily trigger a "double kill" of valuations and profits, resulting in a simultaneous slowdown in capital markets and industry investment. In 2000, as the Federal Reserve continued its rate hikes, tech giants like Cisco, Microsoft, and Intel, experienced a rapid collapse in valuations and stock prices, rapidly altering the growth narrative of the new economy. Capital expenditures significantly declined, and the drop in risk appetite augmented the slowdown in industrial investment, creating a notable negative feedback loop. Likewise, the investment in AI currently plays a critical role in the growth of the US economy and is an indispensable part of the economic framework. By the end of 2025 Q4, AI-related investments made an annualized month-on-month contribution of 1.07% to the US economy, accounting for around half of the total growth. Once rates begin to rise, compelling firms to swiftly reduce their investments could result in a significant amplification of economic downward pressure, becoming a vital force leading the economy towards a recession. Secondly, the dual squeeze effect of rate hikes and rising oil prices could significantly escalate living costs and debt pressure among middle to low-income groups, potentially triggering deeper societal challenges. Currently, economic conditions for middle to low-income groups in the US are more fragile. As outlined in our report on the "K-shaped Divide" in the US economy, its evident that these groups are significantly lagging in economic growth, with economic pressures becoming the central underlying issue in the US economy. In this context, if oil prices rise in synchrony with a rate hike cycle, it would undoubtedly worsen the situation. Rising oil prices directly inflate costs for basic necessities like transportation and heating, eroding already reduced disposable incomes; concurrently, rate hikes mean higher interest expenses for home mortgages, credit card debts, etc., further squeezing household financial flexibility. The tandem impact could force middle to low-income families to cut back on essential expenses, delay major purchases, and even push them to the brink of debt defaults, posing a substantial threat to their quality of life and financial positions, which is highly unfavorable for Trump to navigate in the midterm elections. According to calculations by the Dallas Federal Reserve, the closure of the Hormuz Strait would deliver a significant blow to the economy by the second quarter of 2026, possibly dragging down growth by up to 2.9 percentage points in a single quarter. Although a short-term reopening of the strait might prompt some economic revival, the substantial supply chain disruptions have already occurred, resulting in decreased global supply chain efficiency and inevitable disruptions in inventory management that are bound to impair the pace and scope of economic recovery. In this scenario, should the impacts of rate hikes resonate with those of escalating supply-side shocks and tightened financial conditions, it could potentially plunge the US economy into a severe slowdown. Therefore, whether from the pressures of an economic downturn or political considerations for Trump, the costs and obstacles that rate hikes bring to this administration are undoubtedly substantial. 3) Potential "Milestones" for Resuming Rate Hikes within the Year? So, what conditions could trigger a rate hike by the Federal Reserve this year? We believe that if the Federal Reserve were to resume rate hikes this year, it would need to resonate from multiple facets like inflation sources, demand transmission, and policy constraints: From the source of inflation, if the Middle East situation appears to be stuck for an extended period, sustaining oil prices at $100-120 or even higher throughout the year. According to our previous estimations, in a static model, US inflation could rise to over 3.5% this year, but more crucially, if geopolitical tensions continue to escalate, supply disruptions do not ease, sustained high energy prices could trigger long-term inflation expectations, which would be more critical than a mere rise in inflation readings to shift Federal Reserve policy. Concerning transmission mechanisms, Trump may need to enact more significant fiscal expansions to alleviate demand bottlenecks. During a midterm election year, if Trump follows Biden's lead by implementing substantial fiscal stimuli through resident subsidies, tax cuts, and a series of previously promised affordable support policies directly boosting disposable incomes, quickly activating terminal demand could potentially unblock the chain of transmission of oil prices to downstream investments and consumer spending, which could pose the most significant risk of a second wave of inflation this year. On policy constraints, Fed Chair Powells ability to maintain policy independence is also a key condition not to be overlooked. Compared to Powell, Current Governor Brainard's policy stance leans more dovish, with inclinations during the election campaign to lower rates to about 3%. The political pressure from the White House raises questions about Brainard's readiness to tighten policies, and in the event of his appointment, whether or not he would pivot policy remains uncertain. Furthermore, the transition process within the leadership of the Federal Reserve poses potential risks; should Brainard not pass Senate confirmation smoothly, Powell would continue to hold decision-making authority temporarily, potentially maximizing the likelihood of resuming rate hikes within the year. Therefore, considering the combination of the three main conditions mentioned above, we believe that key indicators to monitor within the year include: marginal changes in inflation expectations (continuity of oil prices), the pace and effectiveness of fiscal policy measures, and the policy articulation and decision inclinations of Brainard in subsequent policy statements; these variables will collectively influence whether the Federal Reserve undergoes any policy changes this year, and the pace and extent of any shifts. But at least as things stand now, given the difficulty of achieving the aforementioned conditions, the hurdles and challenges of resuming rate hikes this year are quite high. Risk Factors: US inflation stickiness exceeds expectations and tariff transmission exceeds expectations; escalation of geopolitical conflicts and a significant rise in oil prices; US fiscal policy exceeds expectations; data calculations are subject to bias.