Bond traders, growing increasingly optimistic about the prospect of an end to Middle East conflicts, now see the next key catalyst emerging from Capitol Hill. Kevin Warsh, nominated by U.S. President Trump as a candidate for Federal Reserve Chair, is set to face questioning at a Senate confirmation hearing. Last week, a brief reopening of the Strait of Hormuz and the potential resumption of U.S.-Iran peace talks drove U.S. Treasury prices higher, with traders increasing bets on Fed rate cuts before year-end. During the period when the war triggered a spike in oil prices, the yield on the 2-year U.S. Treasury note had risen above the upper limit of the Fed's current 3.75% policy rate range. It has since fallen back below that level as oil prices retreated.
Priya Misra, a portfolio manager at J.P. Morgan Asset Management, stated that the significant moves last Friday were "justified because the rates market was still pricing in higher energy prices, which, against a backdrop of inflation above target, would constrain the Fed's room to act." The firm has recently been adding longer-term inflation-sensitive securities to its portfolios, noting that "if oil prices continue to fall, the market can start pricing in a gradual Fed easing cycle."
Although the Middle East situation continues to influence U.S. Treasuries—including new uncertainties around the Strait of Hormuz over the past weekend—Tuesday's Senate confirmation hearing for Warsh also possesses the potential to shake markets. Yields on short-end U.S. Treasuries are returning to levels near the Fed's key policy rate. Even before the U.S.-Israel strikes on Iran in late February, U.S. Treasuries had been rallying, partly on market expectations that Warsh—who had expressed support for lower rates before his nomination by Trump in late January—might push the Fed towards easing monetary policy later this year.
If he indicates he remains inclined to maintain this stance and overlook the war-driven energy shock, it could further solidify market bets on rate cuts and boost interest-rate-sensitive short-term Treasuries. Conversely, any expression of caution regarding inflation could trigger a market reversal. A team of strategists at Morgan Stanley, including Michael Gapen and Lingdi Xu, said, "A key question for the market is the extent to which Warsh would advocate for rate cuts."
After an initial surge in yields driven by spiking oil prices during the early stages of the Middle East war, U.S. Treasury yields have traded within a range in recent weeks. Ceasefire developments and growing expectations for a peace agreement have eased the earlier sell-off, pulling the yield on the 10-year U.S. Treasury note back below approximately 4.25%. Meanwhile, volatility has continued to decline, with a key measure of bond market turbulence largely retreating to near pre-war levels. Market-implied volatility for U.S. Treasuries has subsided after a spike in March.
At the height of the conflict, the market had completely priced out expectations for Fed rate cuts in 2026. As of last Friday, interest rate swaps indicated about a 50% probability of a Fed rate cut by year-end. However, this remains significantly lower than the market's pre-conflict expectation of more than two cuts. Against this backdrop, bond investors will closely watch whether a Fed under Warsh's leadership would prioritize inflation over employment. Some investors believe that with inflation already above the Fed's 2% target, rising oil prices provide a rationale for keeping rates elevated for longer, even if inflationary pressures ease somewhat.
Jack McIntyre, a portfolio manager at Brandywine Global Investment Management, stated, "Unless there is a negative surprise in employment, the Fed should remain on hold for the rest of the year." He added, "If Warsh comes out strongly dovish right away but lacks substantial support within the policy committee, it wouldn't look very good."
George Catrambone, Head of Fixed Income at DWS Americas, noted that while Warsh has pointed to rising productivity as supporting lower rates, his reputation as an "inflation hawk" built during his tenure as a Fed Governor from 2006 to 2011 suggests he will not ignore inflation. "He will be very focused on inflation, and that's what the market wants to hear," Catrambone said, expressing a preference for shorter-duration Treasuries like the 2-year note, whose yield remains above the effective federal funds rate.
Wells Fargo strategists also warned that Warsh's comments at the hearing "could easily shatter the current market perception of him as a dove," noting that options markets may be underestimating potential volatility around the event, which could lead to sharp swings in Treasury yields.
Brendan Fagan, a macro strategist at Markets Live, commented, "Ideally, a Fed led by Warsh would reinforce downward pressure on terminal rate expectations, supporting duration and rate-sensitive assets over the medium term. But in the near term, persistent inflation pressures could keep short-end yields elevated and cap the pace of any yield curve steepening, especially if upcoming data fails to meet the high bar currently required to justify deeper cuts."
Brij Khurana, a portfolio manager at Wellington Management, observed, "Warsh's past stance has been relatively hawkish. More recently, he has focused more on productivity and lower rates. The hearing will provide some clarity." Brian Quigley, a senior portfolio manager at Vanguard, noted that his firm increased its holdings of 2- to 10-year U.S. Treasuries during the yield peak last month. "As long as you are confident the Fed is unlikely to raise rates, holding 2-year Treasuries is attractive," he said, adding that Vanguard's modest overweight in Treasuries with maturities up to 10 years is viable whether the conflict resolves or escalates.
Last week, several Fed officials expressed cautious views on the monetary policy outlook. Cleveland Fed President Hammack said interest rates are currently in a good place, adding, "Depending on the data, we might need to be more accommodative, or we might need to be more restrictive." New York Fed President Williams, a key voice on the Fed board, stated that high uncertainty should prevent policymakers from providing strong guidance on the future path of rates. Fed Governor Waller said that due to the energy shock from the Middle East war, the Fed might need to keep rates unchanged for an extended period if inflation risks outweigh labor market risks.
However, Morgan Stanley strategist Michael Gapen believes Warsh might still leave room for rate cuts later this year, as the current de-escalation in the Middle East war would only cause a temporary rise in inflation. But he added, "We don't think Warsh can be overly dovish on the rate path, as that could raise concerns about Fed independence. Every new Fed chair faces some pressure to prove their anti-inflation credibility, and Warsh will likely be asked under what conditions he believes a policy rate increase would be necessary."
It is also noteworthy that the "transition" process for the Fed Chair is not proceeding smoothly, which could become a variable influencing the Fed's policy path. The confirmation hearing for Warsh before the Senate Banking Committee this week will serve as a platform for senators from both parties to scrutinize his views on the economy and monetary policy. Investors are particularly focused on how Warsh will balance competing forces—pressure from President Trump for significantly lower borrowing costs on one side, and economic conditions that, at least in the near term, do not sufficiently support rate cuts on the other.
Given the Trump administration's repeated criticisms of the Fed and the fact that inflation has been above the central bank's target for over five years, any misstep in answering questions about interest rates could undermine the credibility of a Fed under Warsh's leadership. Yet, even if Warsh's performance at the committee hearing is flawless, his path to Senate confirmation remains uncertain as long as the Justice Department's investigation into current Chair Powell continues.
Senator Tillis, a Republican from North Carolina, has stated he will not support any nominee until the criminal investigation is resolved, believing it threatens Fed independence. President Trump claimed last week he would take action to remove Powell if he does not depart the Fed on time. While Powell's term as Fed Chair expires on May 15, his term as a Board member lasts until January 2028. By convention, an outgoing Fed chair resigns from the institution completely after their leadership term ends, but Powell said in March he would remain until the Justice Department investigation is resolved "in a transparent and final manner."
President Trump indicated he does not intend to drop the Justice Department's investigation into Powell and reiterated the need to probe issues related to the Fed building project. The recent development of U.S. prosecutors raiding the construction site at the Fed headquarters also suggests the Justice Department has not abandoned its investigation into Powell, even after a U.S. district court judge upheld a decision earlier this month to quash a subpoena against him.
If Warsh is not confirmed by May 15, Powell has stated he intends to serve as interim chair and could potentially retain his other key role as chair of the Federal Open Market Committee (FOMC), which sets interest rates. This implies that the Trump administration's continued pursuit of the investigation could not only delay Warsh's confirmation but also allow Powell to retain significant control over monetary policy.
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