Bond traders and Federal Reserve Chairman Kevin Warsh have reached a consensus on a crucial point: the Fed's fight against inflation appears far from over.
The U.S. Labor Department's report showing a month-over-month decline in consumer prices for June, the first since 2020, offered financial markets a brief respite—last week, investors quickly unwound bets that the Fed might begin raising interest rates as soon as this month.
However, this relief is likely only temporary. Oil prices have climbed again following the collapse of the U.S.-Iran ceasefire agreement. While bubble concerns have hit some tech stocks, massive spending in the artificial intelligence sector continues to inject stimulus into the economy.
Warsh, who assumed the role of Fed Chair two months ago, has made it clear that the central bank's top priority is to bring down inflation, which has remained stubbornly above the 2% annual target for the past five years.
Consequently, traders still expect the Fed will almost certainly commence rate hikes before year-end, potentially as early as September.
"If you do nothing, are you confident inflation will return to 2% or 2.5%? The answer is no," said Ed Al-Husseini, a portfolio manager at Columbia Threadneedle.
He is betting that long-term bonds will outperform short-term bills, a position that would benefit from a more hawkish central bank stance. "The Fed should feel more comfortable raising rates without worrying as much about downside risks as before."
Bond traders are anticipating imminent Fed rate increases. Since its final rate cut last December, the Fed has maintained a steady monetary policy stance.
At that time, the job market was rebounding from a February slump, and the war initiated by the former administration against Iran delivered a fresh inflationary shock to the global economy.
These two major shifts shattered the previously widespread expectation that the Fed would resume cutting rates, even after the former president appointed Warsh to replace Powell—a figure he had frequently criticized for not lowering borrowing costs faster.
Warsh has since signaled his eagerness to preserve the Fed's political independence and not yield to pressure. During his first post-meeting press conference as Chair last month, he repeatedly emphasized the need to reduce inflation.
He reinforced this message again last week on Capitol Hill, stating that the June Consumer Price Index data does not mean the Fed's mission is accomplished.
Three other regional Fed presidents—Jeff Schmid, Lorie Logan, and Beth Hammack—have echoed a similar tone.
While traders currently see little chance of a rate hike in July, they still place high odds on a 25-basis-point increase in September or October and view a hike before December as almost a certainty.
Even so, the impact on financial markets may be relatively muted, as U.S. Treasury yields have already climbed in anticipation.
Since late February, the 2-year Treasury yield has jumped about three-quarters of a percentage point to nearly 4.2%, well above the Fed's policy rate range of 3.5%-3.75%.
The broad rise in Treasury yields has, in turn, increased the cost of mortgages and other loans, doing some of the Fed's work by applying the brakes to the economy.
"If we are right about lower inflation and slower growth in the second half, then the market is pricing a more hawkish path for the Fed than we expect," said Chi Chen, co-manager of a $18 billion total return fund at BlackRock.
"The Fed may continue to stay in hawkish territory, waiting for the data to finally moderate."
Therefore, her firm favors intermediate and short-term bonds, whose yields rose during the post-war sell-off. "Valuations are certainly more attractive than before."
The two-year Treasury yield has risen above the Fed's policy rate. Warsh has not revealed when the Fed will act and tends to downplay the central bank's forward guidance on the direction of rates, arguing such guidance can box policymakers in and make them reluctant to change course.
Fed officials will also have little new data or commentary this week as they enter the customary quiet period ahead of their two-day meeting starting July 28th.
Strategist Edward Harrison noted that if the Fed fails to bring inflation down, its "tools" for fighting inflation won't deliver dividends to investors. With the yield curve continuing to steepen and long-term real yields not retreating, Tuesday's bond rally still looks ominously like a "relief bounce."
Economists at Bank of America expect the Fed to raise rates consecutively at its September, October, and December meetings. Following the June CPI data release, they stated in a client note that, given inflation remains well above the Fed's target, "we would need to see several more reports like this to reconsider our current view."
Columbia Threadneedle's Al-Husseini said that in an uncertain environment, a cautious stance is warranted, avoiding heavy bets on positions highly sensitive to Fed actions. "Now is not the time to stick your neck out," he said.
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