CICC: What would happen if the Fed raises interest rates?

CICC released a research report stating that, according to CME data, the market currently expects the probability of a September rate hike to be close to 90%. The U.S. Treasury market is also pricing in a rate hike. The bank believes that a rate hike is not necessarily a bad thing, unless it is a series of consecutive hikes; conversely, not hiking is not necessarily a good thing either. On key assets, apart from U.S. equities (especially tech stocks), which are relatively optimistic, other assets have already fully priced in a September rate hike. U.S. Treasuries: short-term yields are rising, long-term term premiums are falling first, and even long-term bonds as a whole may gradually peak and decline; U.S. equities: not pessimistic, short-term disruptions may even offer better buying points; U.S. dollar: if the Fed hikes, it will rebuild market trust and provide support for the dollar, and vice versa; gold: the room for not hiking is greater than for hiking, and it currently looks more like a bullish option with uncertain upside. CICC's main views are as follows: Whether the Fed should raise rates or not has been the most divisive, wavering, and agonizing question in the market over the past month or so. Warsh's "deliberately vague" remarks at the late-July FOMC meeting on the inflation target and the reflexivity of market interest rates became the starting point of the U.S. Treasury "storm," forcing the U.S. Treasury Department to directly step in and buy back Treasuries, which still did not work. The core issue is not that bond supply suddenly increased so much that it could not be absorbed, but rather concerns that the Fed cannot give everyone the "reassurance" to comfortably hold long-term U.S. Treasuries. Chart 1: The U.S. Treasury term premium once climbed from 0.65% at the end of July to 0.90% in mid-August From that moment on, whether to hike or not was no longer just a question of inflation and the data themselves. That is why Warsh had to re-emphasize at the late-August Jackson Hole meeting the 2% inflation target and that fighting inflation is the Fed's inescapable duty (rather than market rates rising in a self-fulfilling way), using hawkish remarks to stabilize market expectations. This did indeed have some effect, with the term premium, which measures investors' willingness to hold, falling 20bp from its high. From the perspective of safeguarding the Fed's credibility, hiking is the best choice, unless subsequent data all "cooperate" by coming in below expectations. But the data did not cooperate. Since then, several data points such as nonfarm payrolls, PPI, and CPI came in above expectations one after another, and the Fed was indeed "out of luck," gradually being pushed into a "corner," forcing it to honor its hawkish commitment. According to CME data, the market currently expects the probability of a September rate hike to be close to 90%. The U.S. Treasury market is also pricing in a rate hike: since the end of August, the 2-year U.S. Treasury yield has risen 32bp from 4.34% to 4.66%; after deducting the 76bp term premium from the current 4.96% 10-year U.S. Treasury yield, the remaining 4.18% rate expectation reflecting a hike is 60bp above the 3.5% benchmark rate, implying expectations of more than two hikes. Chart 2: The market currently expects the probability of a September rate hike to be close to 90% Therefore, the question has now shifted from "whether to hike" to "what happens after the hike." In the bank's view, the market's problem is often that beforehand it avoids preparing for a rate hike out of fear of its impact, yet after seeing that a hike is unavoidable, it excessively worries about the post-hike shock. The bank believes this is unnecessary. The key is not the hike itself, but why the hike is happening. So, will the Fed hike at this week's meeting? What will happen after the hike? What are the implications for asset allocation? Will it hike in September? The fundamentals are between two possibilities, but from the perspective of safeguarding the Fed's credibility, it is best to hike. As a reference point, if the same words at Jackson Hole had come from Powell's mouth, it would be almost certain that a September hike was coming. At the Jackson Hole meeting, Warsh reiterated the 2% inflation target and stressed that the Fed must fulfill its duties and focus on prices. His tone could indeed be described as stern. But Warsh is not Powell after all. His vague style is the exact opposite of Powell's. He believes that the market's excessive reliance on Fed guidance creates a "hall of mirrors effect" and does not advocate full communication with the market; moreover, his rapport with the market is insufficient. As a result, market expectations remained volatile, and Waller's dovish remarks in early September even temporarily suppressed rate hike expectations. He pointed out that recent inflation showed signs of easing, that energy prices had not yet spread to other price components, and that "disinflation should be given a chance." From a fundamentals perspective, however, it is "between two possibilities." Even if several data points including inflation came in above expectations, evidence that is "not so strong" can still be found. 1) Inflation: the higher August data was mainly driven by factors that seem unlikely to persist, such as oil prices, airfares, and hotels. The bank estimates that unless the oil price center remains above $95, year-on-year CPI by year-end will most likely fall from the current 3.4% level. 2) Growth: U.S. growth is also K-shaped. Although the divergence is not that extreme, under such high interest rates, many traditional demand sectors will quickly come under pressure from high costs, especially real estate. Therefore, fundamental factors are not the decisive weight. Chart 3: U.S. growth is also K-shaped, though a less extremely divergent K-shape From the perspective of safeguarding the Fed's credibility, it is best to hike. This is the key to determining whether to hike. Warsh's "deliberate vagueness" at the July FOMC threw market expectations into confusion, pushing the U.S. Treasury term premium from 0.65% at the end of July to 0.9% in mid-August, forcing Warsh to make a hawkish commitment at the Jackson Hole meeting. If the data had weakened, the Fed would probably still have had room to maneuver, but as nonfarm payrolls and inflation successively came in above expectations, the Fed was gradually pushed into a "corner." Although these short-term indicators all have limitations, before the FOMC there is little else to rely on. Imagine if this meeting still "forcibly refrained from hiking"how would the market view the previous hawkish remarks? It would probably only create a more serious crisis of confidence and out-of-control U.S. Treasuries. What happens after a rate hike? A brief "preventive hike" is often "done in reverse," with the bad news already priced in. The market's problem is that beforehand it often avoids preparing for a rate hike out of fear of its impact, but when it sees that the risk of a hike is unavoidable, it excessively worries about the post-hike shock. When analyzing the impact of a rate hike, why the hike happens may be more important than the hike itself: 1) A prolonged and large rate hike will inevitably have a longer-lasting and larger impact on the real economy and financial markets by raising financing costs and tightening financial liquidity. The most typical example is the 16-month, 525bp hiking cycle the Fed began after the outbreak of the Russia-Ukraine situation in 2022 to address supply-driven high inflation caused by pandemic-related supply-demand mismatches and high oil prices. 2) Conversely, a small or even preventive rate hike, because of its small magnitude, causes limited disruption, and in many cases expectations are already priced in ahead of time, so the hike's arrival often means the bad news is exhausted. There are many "classic cases" in history: If there is only a small or even "preventive" rate hike: because expectations have already been priced in, the hike's landing may instead mean the bad news is exhausted, and it is not necessarily bad for the marketit is all "done in reverse." A typical case is the 1997 rate hike: at that time, the U.S. environment was similar to now, with inflation somewhat warming but not yet out of control, limited financial conditions constraints, and economic growth remaining strong on the back of technology trends. But because the market had gradually digested rate hike expectations before the March 1997 FOMC, after the policy landed, U.S. Treasury yields quickly peaked and fell, and U.S. equities resumed rising within about a week. Chart 4: U.S. Treasury yields hit a stage high of 6.9% shortly after the 1997 rate hike landed Chart 5: U.S. equities began rebounding one week after the 1997 rate hike landed Conversely, the "preventive rate cuts" of 2019, 2024, and 2025 also staged a similar "script." In these three rounds of rate cuts, although the economy faced some downward pressure, there was no risk of a stall, so only a small policy adjustment was needed to provide support. Because rate cut expectations were often already priced in by the market in advance, after the cuts actually landed, the trading mainline would quickly switch from "easing expectations" to "growth improvement." U.S. Treasuries and the dollar index bottomed and rebounded shortly after the cuts landed, reacting most sensitively. Gold also performed better before the cuts than after, unless there was a grand narrative that sharply pushed up gold prices, as in 2025; U.S. equities waited for the rate cuts to transmit to the numerator side, so they still had some gains after the cuts; Hong Kong stocks benefited to some extent from improvement on the denominator side, but domestic fundamentals were the decisive factor. For example, after the September 2025 rate cut, they briefly surged, but that also became the high point of the cycle. Chart 6: In the "preventive rate cuts" of 2019, 2024, and 2025, after the cuts landed, the trading mainline quickly switched from "easing expectations" to "growth improvement" If multiple rate hikes are needed: the market adjustment is larger and longer, typically like the 2022-2023 tightening cycle. Under the dual impact of pandemic supply chain disruptions and the Russia-Ukraine conflict, U.S. CPI year-on-year reached 7-8% in early 2022 and exceeded 9% in June. At that point, monetary policy was clearly behind the curve, and the Fed had to hike rapidly from March 2022 until July 2023, for a cumulative 525bp. This tightening cycle suppressed asset prices for a noticeably longer period. The 10-year U.S. Treasury yield did not peak until October 2023, up 278bp from the start of the hiking cycle, while rate expectations peaked in March 2023, up 171bp; the S&P 500 and gold bottomed in October-November 2022, corresponding to the point when the U.S. inflation inflection was confirmed, with declines of 18% and 16%, respectively. Further excluding the support for risk assets from the AI industry trend since 2023, and looking only at March-December 2022, when the tightening shock was most concentrated, it can be seen that apart from the dollar index (4.5%), which represents cash, and short-term U.S. Treasuries (1.4%), major assets such as equities, long-term bonds, and gold all fell. Chart 7: The 10-year U.S. Treasury yield did not peak until October 2023, while rate expectations peaked in March 2023 Chart 8: The S&P 500 bottomed in October 2022, down 18% Chart 9: Gold bottomed in November 2022, down 16% Chart 10: From March to December 2022, apart from the dollar index and short-term U.S. Treasuries representing cash, all other major assets fell Can it hike continuously and substantially? There is currently no basis for that, unless oil prices spiral out of control. Currently, the basis for consecutive and large rate hikes does not exist, unless the oil price center remains above $95 or even higher for a prolonged period, making it difficult for year-on-year CPI to fall or even pushing it higher. Conversely, the current U.S. economy is K-shaped, and high interest rates in turn suppress traditional demand. U.S. fundamentals may not be able to "withstand" sustained rate hikes, and this will precisely become the "reflexivity" that restrains multiple hikes. Traditional demand has already been constrained by high interest rates. The August ISM manufacturing PMI fell back under the suppression of high interest rates, with the forward-looking new orders sub-index sliding from 56.7 to 53.7. Rate-sensitive real estate data was also affected, with existing home sales falling again. In addition, continued layoffs in the IT and financial industries in recent years may also disrupt consumption. Chart 11: The recent rise in interest rates has pushed previously repaired real estate data down again AI, as an important growth engine, is also becoming more sensitive to financing conditions. As cloud vendors' free cash flow begins to turn negative, U.S. AI investment is gradually becoming more dependent on external financing. Although cloud vendors' ROIC (20%) is still clearly above WACC (9%), against the backdrop of a bottleneck on the AI demand side, a sharp rise in financing costs could weaken cloud vendors' willingness to spend capital. Chart 12: Apart from Microsoft and Meta, cloud vendors' free cash flow in the second quarter has already turned negative Chart 13: Cloud vendors' current weighted ROIC of 19.9% is above WACC of 9% Under what circumstances would it shift to multiple and consecutive rate hikes? 1) Oil prices spiral out of control and remain high for a long time: in the baseline scenario, the oil price center in the third and fourth quarters is $80-90, and the bank estimates that year-on-year CPI will fall to around 3.0% by year-end. But in an extreme scenario, if the oil price center remains at $100 (the average since September) or higher, then year-on-year CPI could exceed 3.6% by year-end, which would put greater pressure on the Fed. 2) If AI capital expenditure again comes in stronger than expected: on the one hand, this would push up technology hardware prices and lift core inflationfor example, in August PPI month-on-month, electronic components were an important contributor; on the other hand, AI already contributes 40% of U.S. GDP quarter-on-quarter. If capital expenditure accelerates substantially, or even spreads to other areas, then it will be difficult for the Fed to use "weak fundamentals" as a reason to cut rates. Chart 14: CPI year-on-year path estimate Chart 15: AI contributed 40% of U.S. growth in the first quarter Implications for assets: A rate hike is not necessarily a bad thing; after the venting, it may instead offer a better buying point; not hiking is not necessarily a good thing. Based on the above analysis of the reasons for rate hikes and the impact of different forms of hikes, the bank's difference from market thinking is that it does not regard a rate hike as a flood or a beast. A rate hike is not necessarily a bad thing, unless it is a series of consecutive hikes; conversely, not hiking is not necessarily a good thing either. This is not to say that a rate hike will not cause disruption, but a brief hike is mostly priced in ahead of time and is often "done in reverse." This was true for the rate cuts of 2024 and 2025, and also true for the 1997 rate hike. Therefore, if it causes disruption, it may instead offer a better buying point. On the contrary, if forcibly refraining from hiking brings a short-term boost, it may create more trouble in the future. Looking at the rate hike expectations for the next year priced into various assets: interest rate futures (3.7 hikes) > U.S. Treasuries and copper (1.7 hikes) > gold (1.2 hikes) > Fed dot plot (0.7 hikes) > Dow Jones (0.6 hikes) > S&P 500 (0.2 hikes) and Nasdaq (-0.4 hikes). Compared with the end of the July FOMC, the 10-year U.S. Treasury rate expectation has risen 15bp, and the 2-year has risen 30bp. This means that apart from U.S. equities (especially tech stocks), which are relatively optimistic, other assets have already fully priced in a September rate hike, similar to the situation before the March 1997 rate hike. Specifically: Chart 16: Looking at the rate hike expectations for the next year priced into various assets, interest rate futures (3.7 hikes) > U.S. Treasuries and copper (1.7 hikes) > gold (1.2 hikes) > Fed dot plot (0.7 hikes) > Dow Jones (0.6 hikes) > S&P 500 (0.2 hikes) and Nasdaq (-0.4 hikes) 1) U.S. Treasuries: short-term yields are rising, long-term term premiums are falling first, and even long-term bonds as a whole may gradually peak and decline. On the one hand, one rate hike corresponds to a center of 4.5-4.7%, and current long-term bond yields have already priced in 1.7 hikes for the year, fully reflecting "preventive hike" expectations. On the other hand, after a rate hike rebuilds confidence, the term premium pushing up long-term bond yields will also narrow. Therefore, U.S. Treasuries already show relatively high "odds" characteristics. Chart 17: If the Fed hikes once, corresponding to a U.S. Treasury center of 4.5-4.7%, there is a trading opportunity 2) U.S. equities: not pessimistic; short-term disruptions may even offer better buying points. In early June, the bank further raised its S&P 500 target to 7800-8000. After the market reached this level, it also began to struggle and fluctuate, first because future AI-driven earnings space still needs catalysts, and second because of disruptions from macro factors such as rate hikes. As the rate hike lands, if there are new catalysts for AI industry development, U.S. equities still have upside; if there is a larger short-term disruption, it can also offer a better buying point. Chart 18: In the baseline scenario, the bank raised its mid-year 2026 S&P target to 7800-8000 3) U.S. dollar: if the Fed hikes, it will rebuild market trust and provide support for the dollar, and vice versa. The bank's dollar model expects the dollar index to fluctuate in the 96-98 range in the second half of the year. Chart 19: The bank forecasts that the dollar index may fluctuate in the 96-98 range in the second half of 2026, and will not weaken substantially 4) Gold: the room for not hiking is greater than for hiking, and it currently looks more like a bullish option with uncertain upside. Based only on static estimates from U.S. Treasury yields and the dollar, gold's support level is around 4400-4600. Unless there are consecutive rate hikes, gold's downside pressure is relatively controllable, but upside also requires more grand narratives. If the Fed does not hike, it can create a grand narrative of lost trust and de-dollarization for gold, while a rate hike precisely weakens this narrative, so the upside is not as great as when there is no hike, and more narrative catalysts must be awaited. Chart 20: The bank's static support level estimate based on U.S. Treasury yields and the dollar is around 4400-4600