By Michael O’Neill

FX markets are convinced that the Fed will raise interest rates in September. That conviction has propelled the US dollar index (DXY) from 99.59 before the FOMC meeting to 101.80 today.

Markets may be about to discover they have mistaken a mirage for reality.

Blame it on the dots, specifically the Summary of Economic Projections (SEP) dot-plot graph which showed a higher median compared to the one in March. Analysts also looked at higher inflation forecasts and concluded the new Chair must be hawkish.

The problem is that conclusion relies on assumptions, and everyone knows what happens when you assume.

Kevin Warsh is the Chair of the Fed, and it is a certainty that Trump did not nominate him for the role, if he was going to raise rates. Warsh revealed very little about his own policy intentions, leaving markets to write the script themselves.

And write they did. The consensus narrative is that higher inflation forecasts mean higher rates, which means the Fed is preparing to tighten policy and that has fuelled demand for the US dollar. It is a great story, but it misses the plot.

No Hike for You

For starters, the inflation projections that helped fuel September hike expectations were prepared when crude oil was still carrying a hefty Middle East war premium. At the time, traders were worried about supply disruptions, shipping risks and the possibility of a broader regional conflict. Since then, those fears have eased considerably. Oil prices have retreated sharply; the Strait of Hormuz is open (at least it is today) and some of the inflation pressure embedded in those forecasts have already begun to fade.

Another hole in the September rate hike narrative is the assumption that Kevin Warsh views inflation through the same lens as the market. He doesn’t.

Warsh has long argued that policymakers should focus on underlying inflation trends rather than react to every short-term price shock. He prefers measures such as the Dallas Fed’s Trimmed Mean PCE and the Cleveland Fed’s Median CPI, as they attempt to filter out the noise created by volatile components like energy and food. To Warsh, they provide a clearer picture of persistent inflation pressures.

The distinction matters. Those metrics suggest inflation is already much closer to the Fed’s 2.0% target than headline numbers imply.

If Warsh convinces a majority of the FOMC voting members to rely on those metrics, the case for a September rate hike may be considerably weaker than markets currently believe.

“Oops, We Did it Again”

It wouldn’t be the first time markets got the Fed wrong. They have, and when they do, the fallout is messy.

In late 2018, investors expected the Fed to continue steadily raising rates well into 2019. Instead, slowing growth concerns forced policymakers to reverse course and begin cutting rates within months.

More recently, in 2023 and 2024, markets repeatedly priced aggressive easing cycles only to watch inflation prove more persistent and rate cuts arrive later than expected.

The 2013 “Taper Tantrum” may be an even better example. Then-Fed Chair Ben Bernanke merely suggested that the pace of bond purchases could be reduced if economic conditions continued to improve. Markets interpreted the comments as the first step toward a broad tightening cycle. Treasury yields soared, the US dollar rallied and risk assets tumbled as investors rushed to price in a more aggressive Fed.

The problem was that tapering asset purchases and raising interest rates were two very different things.

One FOMC Meeting is Not a Trend

Today’s confidence in a September rate hike has a familiar feel. Traders may once again be extrapolating far more from a single meeting than policymakers ever intended. Even more telling, the confidence stems from a meeting where a number of task forces were announced to execute a comprehensive, top-to-bottom review of how the central bank creates monetary policy.

That doesn’t mean a September move is impossible. It means the market’s confidence may be greater than the evidence warrants.

The technical picture suggests traders have embraced the hawkish narrative with unusual enthusiasm. DXY has rallied to 101.80 in little more than a week, while the 5-day RSI has climbed above 90, a level rarely sustained for long. Momentum remains firmly bullish, but the move increasingly resembles a market chasing a narrative rather than waiting for confirmation.

If the preferred inflation measure changes and energy prices continue to slide, traders will quickly discover that they were trading a mirage.