Tonight's US July CPI data will serve as a critical test for whether the Federal Reserve will raise rates in September.

Bank of America Merrill Lynch rates strategist Meghan Swiber and her team published a forward-looking analysis of the US July CPI data. Their baseline forecast is for headline CPI to rise 0.1% month-on-month (3.4% year-on-year) and core CPI to increase 0.2% month-on-month (2.5% year-on-year), both in line with market consensus. The bank maintains its baseline forecast of three rate hikes this year.

However, analysts note that US Treasury yields and the dollar are more sensitive to downside inflation surprises than to equivalent upside surprises. After the June CPI already came in softer than expected, another below-consensus reading in July would directly undermine the foundation for a September rate hike.

Baseline Scenario: Inflation Returns to Trend

Bank of America characterized the June inflation undershoot as a "one-off event" and expects July data to revert to the recent trend. Their baseline predictions include:

Headline CPI: +0.1% month-on-month, +3.4% year-on-year. Despite renewed energy price volatility from Middle East tensions, average gas station prices in July were actually lower than in June, and food inflation is expected to maintain its trend of +0.2%.

Core CPI: +0.20% month-on-month, +2.5% year-on-year, which would be the lowest reading since January this year. Core goods inflation remains subdued, while core services (including housing and non-housing services) are expected to rebound to trend levels, with a monthly increase of around +0.3%.

Risks are balanced in both directions: volatile components like airfares, used cars, and lodging could surprise to the upside, but the downside trend in motor vehicle insurance may persist.

Under this forecast, a September rate hike is not a done deal, with the key still lying in the subsequent path of core PCE data.

Key Judgment: Downside Inflation Surprise Carries Greater Impact

Analysts wrote: "We expect US rates and the dollar to react more strongly to a downside surprise than to an equally sized upside surprise."

The bank forecasts:

If data comes in strong (core CPI +0.3% month-on-month): A September rate hike returns to the agenda, but it won't be "locked in" at this point. With August data still to come before the September FOMC meeting and Chair Warsh's notably cautious stance, the final decision remains uncertain.

If data comes in soft (core CPI +0.1% month-on-month): A September rate hike is essentially ruled out, and this would significantly challenge the market's pricing of approximately 30 basis points of rate hikes for the year.

In other words, strong data merely "opens a door," while soft data "closes one."

US Treasury Yield Market: Downside Reaction More Sensitive Than Upside

The decline in US Treasury yields triggered by a downside inflation surprise is significantly larger than the yield increase triggered by an equivalent upside surprise. Specific numbers illustrate this point:

Analysts note that positioning structures amplify this asymmetry. CTA and active bond funds currently hold substantial short-duration positions, with shorts especially concentrated at the short end. If inflation data comes in soft, short covering would drive a "bull steepening" of the yield curve, magnifying the downside move.

The Bloomberg Fed Sentiment Index also shows that current official rhetoric leans towards a mild hawkish stance, meaning there is more room for officials to pivot dovish after soft data than for them to become more hawkish after strong data.

Dollar: Another Narrative Shift?

The dollar also faces asymmetric risks. Bank of America points out that since Warsh took office, the dollar's trajectory has essentially made a "complete round trip" in tandem with fluctuations in Fed rate hike expectations.

If data is strong: The dollar's recent losses could be partially recovered, but the suspense of August data and uncertainty over Warsh's intentions will limit the rebound.

If data is soft: Hawkish expectations would be materially undermined, a September rate hike would be taken off the table, and year-end rate hike expectations would also be challenged, putting the dollar under further downward pressure.

Bank of America also notes that dollar futures positioning remains net long, while option skews are near neutral. This positioning structure also points to greater downside potential in a soft data scenario.

Core PCE Remains the Fed's True Anchor

Analysts outline three core PCE scenarios:

Scenario One: Core PCE averages 25 basis points or more over the next two months. A September rate hike becomes "almost a sure thing." At that point, core PCE year-on-year would remain at 3.3%, and even with a 20-30 basis point downward revision from methodological changes, it would still be above 3%. Bank of America believes this would be enough to push Waller, Cook, Jefferson, and Barr into the hawkish camp alongside Hammack, Logan, and Kashkari.

Scenario Two: Core PCE averages below 20 basis points. A September rate hike is essentially ruled out. However, Bank of America adds, "Even so, inflation remains elevated, and we still believe higher rates are needed to bring underlying inflation back to 2%," leaving the possibility of a rate hike later in the year.

Scenario Three: Core PCE averages between 20 and 25 basis points. A September rate hike is "a coin flip." At that point, Chair Warsh would have enough votes to support either a hike or a pause. The key then becomes whether his recent hawkish signals are a genuine policy shift or a continuation of his dovish stance from the July press conference.