Bond investors, including those from Brandywine Global Investment Management and Wellington Management, warn that the risk of further declines in US Treasuries is increasing as Federal Reserve Chairman Kevin Warsh leaves market participants uncertain about how policymakers will respond to evolving economic conditions.
Signals from the bond market suggest that Warsh's credibility in fighting inflation is eroding, following his refusal to detail plans for curbing price pressures. Communication breakdowns may deepen: last Friday, media reports indicated he is considering reducing the frequency of the central bank's regular policy meetings. Without clear guidance on how officials will react to upcoming economic data, such as this week's monthly employment report, investors are demanding higher premiums for long-term bonds. Traders are flocking to options markets, betting that long-term bond yields will continue to climb, which ultimately raises borrowing costs for governments, homeowners, and businesses.
The 30-year US Treasury yield, most sensitive to inflation, has surged to its highest level in 19 years. Meanwhile, German Bund yields have hit a 15-year peak due to inflation concerns, and Japanese long-term rates have also risen. "Venturing into the long end of the curve is dangerous," said Brandywine portfolio manager Tracy Chen, who holds a lower-than-benchmark exposure to US Treasuries. "If inflation remains elevated over the next two months and the Fed doesn't raise rates in September, bond vigilantes will act aggressively." Currently, traders see about a 70% chance of the Fed tightening policy at its next meeting in September. For October, the month before key US midterm elections, the market widely expects a rate hike. The Middle East conflict, which has pushed up oil prices and sparked inflation fears, further complicates policymakers' ability to set course. With the war in Iran ongoing, investors worry that higher inflation expectations may become entrenched.
Three Fed officials who opposed holding rates steady warned last Friday that delaying anti-inflation action too long could necessitate more aggressive measures later. Although Warsh has pledged to restore price stability, his vagueness on several key issues has raised doubts about his commitment. He argues that rising bond yields are already doing part of the Fed's work by tightening financial conditions, questions whether the central bank's preferred inflation gauge is still the right target, and notes that interest rates are not the only tool for curbing inflation. According to sources, Warsh has proposed changing the frequency of the central bank's regular policy meetings. A Fed spokesperson declined to comment. Earlier media reports covered this matter. "Given Warsh's focus on transforming the Fed's communication with markets and the public, this is not entirely surprising," said Ben Emons, managing director of fixed income at Highline Asset Management. However, it would still be "like a bombshell" and "would cause market volatility." He added, "Fewer meetings mean a heavy burden on the market."
Curve Signals
Warsh made clear last week that he does not intend to telegraph policy direction to investors and is willing to tolerate any market volatility. "Our purpose is not to create surprises," he said at a press conference after the decision. "But at the same time, I want to say that we approached this meeting with full consideration and were not constrained by the various options before us." Changes in the Treasury yield curve reflect investors' declining confidence in the central bank's policy credibility. After the June meeting, Warsh's first as Fed chair, the gap between short- and long-term yields narrowed rapidly, as the market heard a very clear message from officials: reducing inflation to the 2% long-term target is the top policy goal. A flattening yield curve is a sign of market confidence that inflation will fall over the long term. However, last week, investors flipped the script. They heavily sold long-term bonds, causing the yield curve to steepen significantly, indicating growing market anxiety about inflation due to frustration with the lack of a policy framework from officials. "The current range for US Treasury yields is elevated, with the 10-year yield heading back toward 5%," said Kevin Flanagan, head of investment strategy at WisdomTree. "If data continues to point in a tightening direction, talk is not enough; action must be taken."
Fiscal Background
Concerns about the US fiscal outlook are also pushing yields higher. Investors are also watching this week's auction sizes for 8- to 10-year Treasuries. Strategists say that while the Treasury is expected to keep sizes stable, officials may still pave the way for an increase next year, which would help drive long-term yields higher. "US long-term bond yields are currently at 'attractive levels,'" said Brij Khurana, a portfolio manager at Wellington. However, he fears that "once the market begins to question the Fed's credibility, yields will rise," and therefore prefers holding 5-year inflation-linked bonds.
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