The bond market is yelling at the Fed, but the messages are coming from a variety of directions, creating a dilemma for policymakers trying to strike a balance that doesn’t crush the economy.
U.S. Treasury yields continued to rise on Thursday as investors tried to factor in a variety of factors. These include inflation still running well above the Fed’s 2% target, further spikes in energy prices, and the impact of the global hyperscalers’ financial arms race and associated bond issuance.
Until now, policymakers have been actively watching for spikes in inflation caused by temporary shocks such as rising energy prices or tariffs. And the story not too long ago was that the artificial intelligence investment boom would last a year or two and eventually turn out to be disinflationary.
But now Fed officials are reconsidering the impact of these factors and recognizing the risk of more persistent inflation.
At the same time, markets are grappling with central banks that suddenly have no interest in telegraphing their next moves, leaving it unclear who is the policymaker or the market player.
“The time to get over the initial supply shock is over,” said Joseph Brusuelas, chief economist at RSM. “That bias has to be towards restoring price stability, and they should take seriously what’s going on.”
Markets expect the central bank to indeed take a more robust response to inflation.
Over the past day, traders have raised the possibility of a rate hike in October, just over a month after last week’s quarterly percentage point hike. We also expect a third rate hike later this year or early 2027, with additional rate hikes possible in the coming months.
big switch
That’s a major shift since the Fed said in June it expected to raise rates once this year, and then potentially finish raising rates before beginning lower rates in the next few years.
“My view from the (September) meeting was that there would be three rate hikes,” Bruelas said. But that view changed as his firm modeled the potential for higher yields as AI investment cycles lengthen.
Modeling shows that even if a sharp rise in long-term yields slows growth and increases unemployment, inflation may still not return to 2%. RSM said that even with the 10-year bond yield at 5.5% (from around 5.15% on Thursday), core inflation would remain at 2.4%, while growth would fall to 1.5% and unemployment would rise to 4.7%.
“The Fed is underestimating what it will take to restore price stability. They’re probably not talking about two or three rate hikes, they’re talking about five or six rate hikes,” Bruelas said.
Not everyone on Wall Street agrees. Some strategists think the market is getting ahead of itself. That means current yields essentially factor in stronger economic growth, making them overly sensitive to fluctuations in oil prices amid continued tensions in the Middle East.
“The rise in yields is not due to expectations that the overly dovish Fed will allow inflation to consistently exceed its target. Rather, real yields have risen as investors have priced in the Fed’s rate hikes,” Andrew Hollenhorst, an economist at Citigroup, said in a note. “It is not surprising that this has led to an increase in both short-term and long-term yields.”
In fact, some key Fed officials are advising patience while supporting short-term rate hikes.
restraint case
New York Fed President John Williams, who serves as vice chairman of the Federal Open Market Committee, which sets interest rates, said Thursday it was “reasonable” to expect another rate hike by the end of the year, but noted that officials need to continue to monitor the data before following their pre-set “forward guidance” trajectory of locking in rate hikes.
Similarly, Philadelphia Fed President Anna Paulson has indicated that further policy tightening is likely, but characterized the potential move as “modest,” not that she thinks a series of rate hikes is likely.
Still, the Fed faces a policy crossroads. Too much tightening risks cutting off economic expansion, while too much tightening risks losing market confidence that the economy is adequately adapting to inflation risks.
“Weak guidance guardrails could force both central banks to choose between second-best rate hikes or disappointing markets and risking hard-earned confidence,” Krishna Guha, head of economic and central banking strategy at Evercore ISI, said in a note. “Also, the lack of guidance means that whatever decisions they make risk triggering a significant market reaction, either through a significant tightening or easing of market interest rates.”
While Guha is in the camp that market expectations are “too strong,” he also recognizes the Fed’s dilemma.
“Implementing successive rate hikes, especially without forward guidance on how to interpret rate hikes, risks sending a very hawkish signal and would reprice the interest rate curve to an even more unpredictable range,” Guha said. “However, if the market holds off on rate hikes, which are odds-on, it could lead to significant price increases in another dovish direction.”
The Fed is conflicted
This conflict is now at a crisis point, as Federal Reserve Chairman Kevin Warsh has emphasized letting markets guide policy. This is a major shift from central bank policy since the 2008 global financial crisis, when the Fed used forward guidance tools to indicate to investors the direction of interest rates.
“His framework appears to be heavily reflective of market narratives, rather than rooted in the details of economic indicators,” UBS economist Jonathan Pingle wrote of Warsh. “No Fed chairman has placed more emphasis on considering signals from financial markets as input to monetary policy decisions than Chairman Warsh.”
Market dynamics, including the rise in the 30-year Treasury yield to its highest level since 2004, have transformed Mr. Warsh from someone who advocated lower rates before taking office in May to a chairman who appears to have formed a hawkish coalition on the FOMC.
Indeed, Mr. Pingle speculated that Mr. Warsh, following last week’s post-meeting press conference, “left little doubt” that his views were “more aligned than anyone else on the FOMC” with Cleveland Fed President Beth Hammack, perhaps one of the most hawkish of this year’s voting group.
At least for now, the market’s interpretation is that Mr. Warsh will be guided by the U.S. Treasury market to gradually raise benchmark interest rates.
“There are good reasons why central bankers are starting to worry about overheating in the investment sector of the economy,” said Brusuelas, an economist at RSM. “Mr. Market is suggesting something to policymakers like Kevin Warsh that they should listen to.”
