Compared to his predecessor, Federal Reserve Chair Walsh appears particularly fond of playing guessing games. Whether he is adopting a hawkish or dovish stance, Walsh consistently leaves the market shrouded in mystery.
Citi’s Global Macro Strategy team recently released a research report introducing a new metric: the “Walsh Shadow Rate.” This indicator has currently surged to historically high levels, approaching those seen at the onset of previous rate-hiking cycles. This implies that the risk of a Federal Reserve rate hike in September is rising rapidly, with the upcoming August CPI data serving as the critical threshold determining whether a hike will occur.
Walsh’s “Policy Yardstick”
Many argue that Walsh failed to provide clear policy signals at the Jackson Hole Annual Economic Symposium. In reality, however, he has laid out his decision-making framework on the table. While he did not specify the exact weighting of each indicator, he clearly distinguished between “core observables” and “secondary observables,” which in itself constitutes the most significant guidance.
The Citi report points out that what Walsh places at the core is the trend change in core PCE, rather than single-month data fluctuations; it is the breadth of inflationary pressure—i.e., how many categories of prices are still rising—rather than a single inflation reading. Furthermore, indicators highly correlated with the market, such as initial jobless claims, the unemployment rate, money supply, credit spreads, overall financial conditions, and even corporate earnings and capital expenditure, are all included in his priority list.
Conversely, indicators whose importance he has explicitly downplayed include inflation expectations and wage growth, which have been widely discussed in the market, as well as the monthly non-farm payroll additions that typically stir market nerves.
The report uses rolling three-year Z-scores to measure the temperature of various indicators—the higher the value, the hotter the data relative to history. The results are clear: the indicators Walsh focuses on are almost entirely in the hot zone, pointing to sticky inflation and a heated economy; whereas the indicators he deems “less important” have mostly begun to cool down, signaling an economic slowdown.
In other words, his attention is more focused on data that “supports rate hikes,” which in itself represents a clear hawkish posture.
In particular, Walsh highlighted the breadth of inflation, an indicator that had previously received limited market attention. He believes that inflation breadth reflects underlying inflationary pressures; as long as it remains elevated, one cannot easily conclude that a downward trend in inflation has been established, even if single-month CPI figures decline. Although historical patterns suggest that inflation breadth is more of a lagging indicator, variables singled out by the Federal Reserve Chair must be incorporated into the market’s observational framework.
“Walsh Shadow Rate” Hits Highs
To quantify Warsh’s policy inclination, the Citi team calculated the median Z-scores of the indicators he closely monitors to construct a “Warsh shadow interest rate,” which measures the implied degree of tightening in the current economic and market environment.
This shadow interest rate reveals two key conclusions:
First, the current reading is approaching historical highs, a level at which the shadow rate has typically stood at the onset of previous hiking cycles. The only exception was the easing period following the financial crisis, during which Warsh himself left the Federal Reserve in early 2011 due to his dissatisfaction with continued quantitative easing.
Second, this shadow interest rate usually leads$U.S. 2-Year Treasury Notes Yield (US2Y.BD)$changes, with its leading indicator property being particularly pronounced before the start of hiking cycles. This implies that if Warsh were indeed to make decisions based on this framework of indicators, the Federal Reserve’s tightening actions could be faster and earlier than in previous rounds.
Of course, this does not mean that a rate hike in September is a foregone conclusion. Citi’s team of economists maintains its baseline forecast of no rate hike in September, citing the high probability that subsequent inflation data will continue to cool. Nevertheless, it is undeniable that the risk of a rate hike has risen significantly since before the Jackson Hole symposium, and the policy balance has clearly shifted toward the hawkish side.
August CPI Becomes a Critical Watershed
The core variable determining whether rates will be raised in September now rests solely on the upcoming August CPI data.
FOMC member Waller has explicitly stated that inflation is at a “turning point,” and the August CPI will be a key basis for the September decision. Citi’s estimated threshold is roughly as follows:
If the month-on-month core CPI exceeds 0.3%, a rate hike is virtually certain;
If the core CPI month-on-month growth is only 0.1%, a rate hike will most likely be postponed;
If it is 0.2%, the situation becomes more ambiguous—the year-on-year reading will continue to decline, but whether this will be enough to persuade Warsh to pause remains uncertain.
The diminishing importance of non-farm payroll data stems from Warsh having downplayed the weight of new job creation. Even a slight rise in the unemployment rate may not be sufficient to dispel the idea of a rate hike, unless non-farm payrolls show consecutive negative growth, which is not Citi’s baseline forecast scenario.
Additionally, it is important to note that the FOMC is not uniformly hawkish. There were already few dissenting members voting for a rate hike at the July meeting, and the majority of members struck a more dovish tone than Warsh did at Jackson Hole.
Some emphasize that current policy is already sufficiently tight, while others argue for prioritizing macroeconomic fundamentals over financial conditions. How many members Warsh can sway toward a hawkish stance as Chair remains unknown, leaving suspense for the September meeting.
Bessent’s U.S. Treasury Bond Dilemma
One of the individuals most troubled by the Federal Reserve’s shift toward a hawkish stance is U.S. Treasury Secretary Bessent.
The Treasury Department is already issuing large volumes of coupon-bearing Treasury bonds that require market absorption, and a hawkish Fed would directly suppress demand for long-end U.S. Treasuries. Following the Jackson Hole symposium,$U.S. 10-Year Treasury Notes Yield (US10Y.BD)$surged significantly,$U.S. 30-Year Treasury Bonds Yield (US30Y.BD)$It has also edged higher, approaching the 5.3% level widely recognized by the market as the "Bessent line"—the approximate threshold at which the Treasury Department previously intervened to stabilize long-end interest rates.
Compounding the situation, oil prices continue to rise. Although the long-term impact of oil prices on long-end interest rates should not be significant, recent price trends are indeed pushing up inflation expectations, adding further upward pressure on long-end rates.
Citi believes that if the Federal Reserve actually raises interest rates in September, the yield on 30-year U.S. Treasuries is likely to break through 5.3%. Once this key level is breached, the Treasury Department will likely introduce additional measures to suppress long-end yields, such as adjusting the maturity structure of debt issuance and increasing long-bond purchase operations. Such interventions, bearing characteristics of "debt monetization," would in turn serve as a significant positive catalyst for gold.
How do major asset classes perform around the time of the first rate hike?
If the first rate hike of this cycle indeed occurs in September, how will equities, bonds, gold, and foreign exchange markets respectively perform? Citi reviewed asset price movements before and after each first rate hike since the 1980s and identified several clear patterns.
Regarding U.S. equities, after the implementation of the first rate hike,$S&P 500 Index (.SPX.US)$they typically experience a short-term weakness lasting approximately 50 trading days, followed by a recovery and an overall upward trend. This time, supported by the AI industrial cycle, the growth logic at the individual stock level is stronger, suggesting that the magnitude and duration of any correction may be more limited.
Regarding U.S. Treasuries, bonds face significantly greater pressure than equities. The market prices in rate hike expectations in advance, so bonds begin to decline before the first rate hike; after the hike is implemented, bonds continue to weaken, typically bottoming out after approximately 80 trading days. In other words, the adjustment period in the bond market is longer and the trend is more certain.
Regarding gold and foreign exchange, gold shows no particularly clear unilateral trend before or after the first rate hike, with median returns remaining largely flat and wide fluctuation ranges. The U.S. Dollar Index usually strengthens before the rate hike, while the euro tends to weaken against the dollar before the hike and gradually stabilizes afterward. However, over a longer horizon, both gold and the euro tend to turn upward approximately 60 trading days after the first rate hike.
Regarding volatility,$CBOE Volatility S&P 500 Index (.VIX.US)$The MOVE Index (U.S. Treasury volatility index) generally fluctuates within a range around the time of the first rate hike, without experiencing sustained sharp spikes. Bond volatility tends to rise significantly only during rare periods of aggressive rate hikes.
Gold and U.S. Equities
Returning to current asset allocation, gold and U.S. equities are the two most closely watched assets, yet their underlying investment logics are fundamentally different.
The short-term pressure on gold is clear: as Waller shifts toward a hawkish stance,$U.S. 2-Year Treasury Notes Yield (US2Y.BD)$having reclaimed the 55-day moving average, gold has historically performed weakly in this interest rate environment. Citi previously went long on gold due to Treasury intervention in long-end yields, but has since given back some of those gains.
However, the long-term thesis for gold remains intact. If$U.S. 30-Year Treasury Bonds Yield (US30Y.BD)$yields break above 5.3%, forcing the Treasury to intervene to stabilize the bond market, gold would see a second wave of upward momentum. Consequently, Citi has closed its euro long positions to reduce portfolio risk but retains long positions in gold and October federal funds rate futures, betting on the Fed holding rates steady.
The situation for U.S. equities is much more favorable. Many worry that high interest rates will crush the stock market, but historical data shows that as long as U.S. Treasury volatility does not spike sharply, U.S. stocks can maintain positive returns even with yields at elevated levels. The MOVE Index remains within a manageable range, so a simple rise in interest rates is insufficient to derail U.S. equities.
More importantly, the current macroeconomic environment still favors a 'Goldilocks' scenario: the economy is resilient, inflation is declining, and productivity gains from AI technology can boost real growth without triggering inflation. This environment is highly similar to the tech cycle of the 1990s, during which U.S. equities typically performed well.
Overall, the global macro market is at a critical juncture: if August CPI comes in low, the Fed holds steady, equities and bonds rebound, and gold stabilizes; if it trends the other way, the first rate hike occurs in September, the bond market continues to adjust, U.S. equities face short-term pressure, and the U.S. dollar strengthens. For investors, the most important task now is not to bet on one outcome, but to prepare for both scenarios, monitor core signals, and manage portfolio risk effectively.
Editor/melody