Where to start

After the unexpectedly weak July nonfarm payrolls data in the US, the market's expectation of a September rate hike by the Federal Reserve has sharply cooled. The S&P 500 broke a months-long stalemate, hitting a new record closing high. The CME FedWatch tool shows that before the data release, the interest rate futures market had priced in a September rate hike, with the probability of a hold at just 45%. After the data, this probability surged to over 60%.

Assessing the extent of priced-in tightening threats

How much of the Fed's tightening threat has the stock market already priced in? Doug Peta, head of the fundamental platform at global investment research firm BCA Research, noted in a seminar that the current US stock market is caught in a mix of mixed macroeconomic conditions and strong corporate earnings. Despite investor concerns about the tightening environment, the market has still hit new highs on solid fundamentals. He believes that money markets are currently pricing in about two rate hikes over the next year, while BCA's baseline forecast suggests the Fed will hike at most once more. If subsequent cooling inflation confirms the Fed does not need to over-tighten, the gap between actual rate hikes and market pricing could provide further upside momentum for US stocks.

Market overpricing of rate hike threats?

Peta mentioned that based on communications with institutional clients and pricing in the overnight indexed swap (OIS) market, money markets had previously leaned toward a more hawkish environment for the Fed by year-end and into the first half of next year. The OIS curve, a key proxy for money market views, showed traders broadly expected another rate hike this year, fully pricing in two 25-basis-point hikes over the next year. At the July 30 policy meeting, the Fed voted 9-3 to hold rates steady, the most divided vote since September 2016. Fed Governor Christopher Waller warned against repeating the mistake of "waiting too long" as in 2021. St. Louis Fed President Alberto Musalem confirmed in early August that he had favored a 25-basis-point hike at the July meeting, arguing for a gradual, moderate tightening now rather than risking a larger, more rushed move later if inflation pressures accumulate. He also warned that tolerating persistently above-target inflation itself threatens the Fed's credibility.

Signs of easing inflation pressures

However, Peta argued that the financial market's pricing of the Fed's rate hike path may have been too hawkish. On compensation metrics, all three key wage growth indicators tracked by the Fed have fallen to the 3% to 3.5% range. With labor productivity growing at a 1% to 1.5% annualized rate, this wage level is consistent with the Fed's 2% long-term inflation target. Meanwhile, as the impact of tariffs fades, goods prices are returning to deflationary trends. In the housing market, with a large pipeline of multi-family housing supply, rent prices are expected to continue falling. The recent weak employment data may also force the market to unwind its hawkish pricing. On August 5, the ADP employment report showed US private sector added just 44,000 jobs in July, well below the 70,000 expected. Two days later, the Bureau of Labor Statistics reported that nonfarm payrolls fell by 23,000 in July, with May and June data revised down by a combined 103,000 jobs.

Market reaction to weak data

Stephen Innes, managing partner at SPI Asset Management, believes this "surprise" nonfarm report is a classic "bad news is good news" reaction, with weak data enough to allow the Fed to "ease off the rate hike brake a bit." James Knightley, chief international economist at ING, said the weak data significantly reduced market expectations of near-term Fed rate hikes, supporting the view that the Fed will hold steady for an extended period. Brian Levitt, global market strategist at Invesco, previously noted that with inflation expectations still anchored at low levels, even if the Fed hikes again this year, it would be a "one-time" fine-tuning at the end of this tightening cycle. He also predicts the Fed will eventually pivot to rate cuts in 2027.

Wealth effect's role in consumption

Even if weak hiring data removes the threat of Fed rate hikes, a key question is whether the US economy and consumer can sustain the "soft landing" narrative. Peta highlighted a hidden concern between disposable income and consumption. Since hiring slowed in April 2025, real disposable income growth, adjusted for inflation, has fallen to -0.4% annualized, while real consumption spending has grown at a 2.3% annualized pace. This gap has pushed the personal savings rate down to 2.8%, near levels not seen since the eve of the subprime crisis. This low savings rate yet strong consumption is largely driven by the "wealth effect" from the stock market rally. Peta cited Fed data showing that US households' stock and fund holdings are now about three times their disposable income. Across income, wealth, and age groups, the share of stocks in household net worth has reached two to three times the levels since record-keeping began in 1989. With lower barriers and costs for stock investing, penetration among middle-class and broader consumer groups has hit a record high.

Dual-edged nature of wealth effect

However, Peta specifically warned that this asset price-driven consumption pattern has a clear "double-edged sword" feature. When the stock market is in a bull run, wealth gains can support consumption despite low savings rates. But this also means US economic activity has become much more sensitive to stock market volatility. If the market faces a cyclical downturn, the negative impact of wealth erosion on consumption and the macroeconomy will be far greater than historical averages.