Just a short time ago, investors in the U.S. Treasury market were confident the "Warsh trade" was a sure bet: simply wager that incoming Federal Reserve Chair Kevin Warsh would implement multiple interest rate cuts upon taking office. However, with only days remaining until Warsh officially assumes leadership of the Fed, market sentiment has shifted. Against a backdrop of strong U.S. economic performance and geopolitical tensions fueling inflation concerns, the $31 trillion U.S. bond market is now pivoting towards bets on tighter monetary policy. The yield on the 30-year U.S. Treasury is approaching the 5% mark, while the previously popular steepener trade, predicated on expectations of monetary easing, has largely faded.
The steepener trade was based on the market's expectation that Warsh, upon becoming Fed Chair, would push for rate cuts to depress short-term yields while using balance sheet reduction to lift long-term yields, creating a scenario where the Treasury yield curve steepens. Currently, investors do not necessarily believe Warsh has suddenly abandoned his policy stance favoring cuts and quantitative tightening. Rather, they have soberly recognized that this incoming chair, whom some have derided as a "puppet" of former President Trump, will ultimately, like all his predecessors, be constrained by evolving economic conditions. "It will be economic events, not ideology, that determine his policy choices," stated Adam Marden, Co-Head of Global Bond Strategy at T. Rowe Price.
The ebbing of the "Warsh trade" momentum makes an already complex bond market even more difficult to decipher. The situation with Iran, causing significant oil price volatility, has become a core disruptive factor for short-term rate direction. Although inflation concerns are mounting, the bar for the Fed to either hike or cut rates remains very high, further intensifying internal policy disagreements at the central bank. Concurrently, artificial intelligence is boosting economic growth and fueling market risk appetite. These multiple variables are making Treasury market movements increasingly complex. "This is a very difficult market to trade and a very difficult market to analyze," said Priya Misra, Portfolio Manager at J.P. Morgan Asset Management. "AI is creating capex, bond supply, and lifting optimism about the long-term growth prospects of the U.S. Meanwhile, we are living through one of the biggest shocks in energy ever."
Despite the increased difficulty in market analysis, several investment banks have provided forecasts for the path ahead. Strategists at Bank of America noted that the market is currently significantly underestimating the potential for the Fed to raise interest rates, with the probability of a hike rising further after April's strong jobs report. One trading strategy recommended by BofA strategists is to bet on a rise in the two-year U.S. Treasury yield. This view aligns with that of T. Rowe Price's Marden, whose global fund is shorting U.S. Treasuries, betting the Fed will maintain a tight monetary policy in the face of economic resilience and resurgent price pressures.
Warsh has previously stated that productivity gains from AI could dampen inflation and lead to lower interest rates. However, Marden remarked, "If CPI is 3.5% by September, he won't be talking about productivity anymore." Investors are closely watching Tuesday's U.S. CPI report to assess the Fed's policy resolve amid high oil prices. Economists expect the indicator to have risen 3.7% year-over-year, marking a new high since 2023. An "overheated" CPI report could completely reshape expectations. Jordi Visser, Head of AI Macro Nexus Research at 22V Research, suggested the report "could be more than just confirming another uncomfortable inflation print." He posits that the trend over the last two months looks more like a re-run of the 2022 inflation explosion than the "disinflation" narrative the market had firmly believed in.
Interest rate swap trading indicates traders now see a nearly 60% chance of a Fed rate hike by April 2027. This stands in stark contrast to the period just before the Iran conflict erupted in late February, when traders were pricing in multiple rate cuts. Some strategists believe that despite the complex market environment, Warsh will still attempt to shape a distinct policy style. Analysts at Morgan Stanley noted that a Fed under Warsh might pivot to a new inflation metric, reduce forward guidance, and accelerate quantitative tightening, which could mean significantly heightened volatility in the Treasury market.
However, other analysts remain convinced the "Warsh trade" will ultimately return, with the core logic being that economic weakness or cooling inflation will restart rate cut expectations. The current high level of the 10-year Treasury yield has already pushed up costs for auto loans and mortgages, acting as a drag on the economy. If oil prices remain elevated for an extended period, the risk of an economic downturn will increase further. "The window for the Warsh trade to come back is a significant weakening in the labor market. That's not the environment we're in right now, but it could be by the end of the year," said Ed Al-Hussainy, Portfolio Manager at Columbia Threadneedle.
Based on this view, Andrew Szczurowski, Investment Manager at Morgan Stanley Investment Management, is positioned long on short-term Treasuries. He believes the Fed will ultimately cut rates to stabilize employment, and the recent adjustment in Treasuries presents a buying opportunity. "I still think the majority of Fed officials believe the next policy move is a cut," Szczurowski said. "Whether it's in nine months or 12 months, that's fine."
Comments