10-year US Treasury yields approach 5%, US stocks pull back: Goldman Sachs remains bullish against the trend—an “insurance-rate hike” or the restart of the tightening cycle?

According to Zhitong Finance APP, this week the biggest suspense for the Federal Reserve's policy meeting may no longer be about whether to raise interest rates.

According to CME FedWatch data, after the August CPI report was released, the market's pricing for a 25 basis point rate hike in September jumped from about 70% previously to nearly 90%, and as of this writing, it still remains above 86%.

David Mericle, chief U.S. economist at Goldman Sachs, directly changed his prediction in last Friday's research note—from forecasting "no action" to now expecting a 25 basis point hike in September, using very straightforward language: "With the market already pricing in nearly a 90% chance of a hike, if the Fed decides to hold steady, it's likely to trigger sharp market volatility." TD Bank and JPMorgan, which had been hesitant earlier, also changed course. KPMG Chief Economist Diane Swonk summed up the current market consensus in one sentence: "The question now isn’t whether they will raise rates, but how much they need to raise to rein in inflation."

So, what is the remaining 10% probability betting on? It's betting on whether Fed Chair Walsh can find a coherent path between "hawkish rhetoric" and "actual action."

The 'surface' and the 'substance' of the inflation data

The August CPI data made it difficult for the market to continue telling the story that "inflation is steadily trending down."

On the surface, the numbers don't look too bad—CPI rose 3.4% year-on-year, in line with expectations, and core CPI even dropped to 2.4% year-on-year, the lowest since March 2021. But the devil is in the month-on-month data. Core CPI rose 0.3% MoM, higher than the expected 0.2%, marking the strongest monthly increase since April.

A breakdown is even more concerning. Housing prices rose 0.3% MoM; communications services surged 2.3%; airfare skyrocketed 2.7%. Wireless telephone service prices soared 5.94% in a single month, a record high—according to Inflation Insights’ Omair Sharif, this item alone contributed 10 basis points to core CPI. This is no longer just energy prices "carrying the load"; inflation is spreading to a broader range of sectors.

According to Stephen Brown, chief North American economist at Capital Economics, based on CPI and PPI data, the Fed's preferred core PCE deflator is expected to rise 0.28% MoM in August. This is enough to push the year-on-year core PCE from 3.3% to 3.4%—well above the 2% target. Brown’s conclusion is blunt: "A rate hike is very likely to gain broad support within the FOMC."

Combined with the earlier release last week that August PPI rose 5.4% YoY, higher than the expected 5.3%, and Brent crude spiking above $109/barrel due to Middle East tensions, the pressure on inflation is no longer temporary.

Walsh's Crucial Test of Credibility

This meeting carries unusual weight for Walsh.

The new Fed Chair, who only took office in May, made his debut at Jackson Hole in late August with a decidedly hawkish tone. He stated that even though summer inflation data was better than expected, "this does not tell me meaningful progress has been made in the underlying trend." If policymakers fail to see clear evidence that inflation is moving toward the 2% goal, they "have more work to do." Yet Walsh avoided specifying a policy reaction function or clarifying whether a rate hike in September was needed, saying, "I'm standing here today promising discipline, not a decision."

This rhetoric triggered a subtle reaction in the markets. Inflation Insights' Sharif wrote in a client note: "For the Fed, it's time to put up or shut up." Sharif's meaning was clear—Walsh can't give a speech like at Jackson Hole and then not support a rate hike at the subsequent meeting. Economists Anna Wong and Andrew Sacher also bluntly stated that if the Fed does not hike, Walsh's credibility among market participants will be lost.

This pressure is not unfounded. Walsh failed to satisfy investors in the press conference after the July policy meeting. JP Coviello, Head of Citi Wealth Portfolio Strategy, said: "The market still has some concerns about Fed independence."

In other words, this meeting is not just about interest rate decisions, but also a market assessment of Walsh's personal credibility.

The Tug-of-War in the U.S. Stock Market

With rate hike expectations rising, U.S. stocks are clearly feeling the pressure.

The S&P 500 is still up nearly 12% so far this year, but it has pulled back several times recently and is currently about 2% below its record high in mid-August. Investors are particularly alert to moves in the bond market—the 10-year Treasury yield briefly touched 4.99%, nearing the psychological 5% threshold. Institutions such as JPMorgan and Barclays have previously warned that a 10-year yield at 5% would significantly dampen equity sentiment.

Cayla Seder, State Street's Macro Multi-Asset Strategist, said: "We are in a period full of uncertainties. Yields are rising, rate hike expectations are rising… the market needs to price in overall tension."

But not everyone is bearish. In a September 11th report, Goldman Sachs offered a contrarian view: rising rates do not equal a falling stock market; earnings growth is the key to a bull market. Goldman's argument is that the "yield spread" between the S&P 500's earnings yield (5.2%) and the real 10-year Treasury yield (2.6%) is currently 270 basis points and has remained stable over the past two years—the relative value of stocks to bonds has not systematically deteriorated.

Goldman also reviewed data from the past seven rate hike cycles over the decades: within three months after a rate hike begins, the average S&P 500 return is -2%, with only a 29% probability of a positive return; but within twelve months, the average return is +9%, with positive returns in every instance except 2022. The 1997 case is particularly instructive—the Fed raised rates by only 25 points, the S&P 500 immediately fell 10%, but when the market stopped pricing in further tightening, stocks bounced and set new highs within three months.

The logic behind this historical pattern is not complicated: the medium-term impact of rate hikes on stocks ultimately depends on how monetary tightening affects earnings growth. As long as corporate earnings continue to grow, valuation compression will be limited. However, Goldman also cautions that about 75% to 80% of the S&P 500’s net present value comes from cash flows more than 10 years out. This means stock valuations are much more sensitive to long-term rates than to short-term, and interest rate volatility itself is a risk factor.

Will a One-Off Hike Start a New Tightening Cycle?

If a rate hike does occur, the market’s main concern will actually be another question: Is this a one-off "insurance hike," or the start of a longer tightening cycle?

"If it signals a cycle—for example, if they say they have more work to do—I don’t think that’s good for the market," said Alicia Levine, Chief Investment Officer at BNY Wealth.

This divergence is reflected directly in bond market pricing. After the August CPI release, 2-year Treasury yields rose about 4 basis points, the 10-year barely changed, while the 30-year actually fell 2 basis points, flattening the curve. This pattern—short end up, long end down—shows the bond market is more inclined to see this hike as "the Fed taking the inflation target seriously" rather than the start of a new tightening cycle.

The upcoming FOMC statement and Walsh's press conference will be the key moments to test this judgment. If the statement is hawkish and hints at further moves, the market may react first with a flatter yield curve and stocks under pressure. But if Walsh conveys that "this rate hike is a disciplined response to inflation data, not a full pivot to tightening," then market tension may be relieved.

In any case, global markets are experiencing a delicate moment. Seder said: "If the Fed doesn't hike rates and the market rallies, I think that could be an opportunity to reduce holdings. Because there's another possibility—they hold still in September, but may act at some later point."

This sense of unresolved suspense may be more unsettling to investors than the rate hike itself.