The market is still betting on rate hikes, but UBS pours cold water: The Federal Reserve won't turn hawkish suddenly

Recently, UBS refuted market pricing on the Federal Reserve's rate hikes, arguing that cooling wages and diminished tariff impacts support the Fed keeping rates unchanged. The bank views the current elevated yields as an opportunity to buy high-quality short- and medium-term bonds, rather than a level to avoid.

Federal Reserve Chair Kevin Walsh stated at the European Central Bank's annual forum on Wednesday that he would adhere to the Fed’s 2% inflation target and would “disappoint” anyone expecting a different outcome.

Walsh reiterated that the Fed is committed to price stability, while pointing out that inflation risks have moderated in recent weeks and inflation expectations have softened. However, he gave little indication of his views on future policy or the economic outlook and declined the market’s attempts to extract forward-looking guidance from his remarks.

Following his speech, the yield on the 10-year U.S. Treasury rose by 5 basis points to 4.47%. Currently, market pricing indicates about two 25-basis-point rate increases by the Fed over the next 12 months. UBS insists that such market pricing around Fed hikes is too aggressive.

The bank believes there is a disconnect between strong overall employment data and slow wage growth. Labor market resilience has not translated into significant price pressures. UBS noted that ADP data show private sector employment increased by 98,000 in June, marking one of the strongest three-month hiring periods in over a year; yet at the same time, average hourly wage growth continues to slow.

UBS also pointed out that if the scale of labor replacement brought by artificial intelligence exceeds expectations, the Fed’s attention might shift to downside risks in employment rather than inflation risks.

Regarding the inflation outlook, the bank expects inflation to continue slowing this year.

Although AI-driven demand remains a potential upside risk for inflation, the bank’s analysis suggests that the impact of tariffs is increasingly likely to take a disinflationary path in the second half of the year. The fading transmission effect of tariffs could reduce the inflation trend by 0.8 percentage points over the next 12 months.

Oil prices have also returned to levels seen before the U.S.-Iran conflict. UBS expects that as traffic through the Strait of Hormuz gradually resumes, supply bottlenecks will ease further, even if peace talks might still face setbacks.

UBS also noted that the ongoing institutional review at the Federal Reserve is another source of recent policy inertia.

Walsh stated that key appointments to the five working groups responsible for reviewing Fed operations will be announced next week, and hinted that some groups may include officials from foreign central banks. He also expressed hope that within a year the Fed will shift towards using real-time data instead of relying mainly on lagging government survey data.

UBS expects this review process will delay major policy adjustments in the short term.

Overall, the bank believes the Fed will keep rates unchanged, and there is room for the market to lower tightening expectations. UBS says this dynamic should benefit high-quality short- and medium-term bonds, as yields will decline; the bank also sees current high yields as an opportunity for investors to lock in durable portfolio returns.