The 10-year U.S. Treasury yield has climbed to 4.48%, the 30-year yield has surpassed 5%, and the 2-year yield has moved above the upper bound of the Federal Reserve's target interest rate range. Market expectations for a rate hike within the year have now exceeded 30%. This repricing in the bond market is constraining the policy flexibility of the new Federal Reserve Chair, Warsh.
Before Chair Warsh has even presided over his first Federal Open Market Committee meeting, the bond market has delivered a de facto "rate hike."
On Thursday, May 14th, data showed U.S. retail sales in April posted their strongest gain in eight months. The figures confirmed the resilience of consumer spending but also highlighted persistent inflationary pressures, dashing hopes for near-term rate cuts.
Following the data release, the interest-rate-sensitive 2-year Treasury yield rose by 4 basis points to above 4%. The benchmark 10-year yield climbed to 4.48%, representing an increase of approximately 50 basis points since late February.
This bond market repricing is eroding the policy maneuvering room that the new Fed Chair, Warsh, might have otherwise possessed. Vincent Ahn, a fixed income portfolio manager at Wisdom, stated bluntly that Warsh likely hoped to have the option to cut rates on his first day, but the bond market has already taken that option off the table.
**Bond Market Runs Ahead, Lifting the Entire Yield Curve**
Yields have risen across the approximately $30 trillion U.S. Treasury market.
The yield on the 30-year U.S. Treasury broke through the 5% level this week. Although it briefly retreated below 5% overnight, it ultimately closed at 5.030%.
Furthermore, the 2-year yield moving above the Fed's current short-term interest rate target ceiling of 3.7% is particularly noteworthy.
Typically, the 2-year Treasury yield does not persistently trade above the federal funds target range. This abnormal pattern suggests that, before Warsh's first scheduled policy meeting on June 16-17, the market has already effectively implemented a rate hike on its own.
Vincent Ahn characterized this as a classic move by the "modern bond vigilantes":
They are not seeking to destroy the Fed's credibility with a single sharp spike in yields. Instead, they are gradually eroding its policy options by pushing the entire curve above the policy range.
**Persistent Inflationary Pressures, with Oil as a Key Variable**
Behind the bond market tightening are inflationary signals from the real economy.
Since the outbreak of the Iran War, oil prices have surged significantly, with the U.S. national average price for gasoline exceeding $4.50 per gallon.
Erik Aarts, a senior fixed income strategist at Touchstone, recently paid over $6.50 per gallon while refueling in California. He described this as not only "very painful" but also a constant reminder that sustained high oil prices, by eroding household disposable income, will create a tangible drag on consumer spending.
Many Americans have no alternative for their commutes and must continue to bear higher fuel costs, but this means the portion of wages available for other consumption is shrinking. Aarts stated:
The threshold for the Fed to hike rates is being lowered.
Data from the CME FedWatch Tool shows that as of Thursday, market-implied probability for a Fed rate hike by early December has surpassed 30%. The probability of rates remaining unchanged is about 60%, while the chance of a cut is a mere 1.3%.
Despite rising inflation expectations, the reality of the labor market imposes constraints on the Fed's decision-making.
The unemployment rate held steady at a relatively low 4.3% in April, but overall labor market momentum has nearly stalled. Brij Khurana, a fixed income manager at Wellington, emphasized the Fed's high regard for the labor market.
He pointed out that the current drivers of inflation are markedly different from the wage-driven inflation of 2022. New concerns about job displacement due to artificial intelligence replacing white-collar roles are also circulating in the market. He said:
We are almost examining the situation minute by minute.
In his view, as the Iran War continues, the conflict's impact on economic growth will be more profound than its inflationary shock.
**Historical Precedent: New Chairs Facing Market Tests**
Jim Reid of Deutsche Bank notes that the perception of new Fed Chairs quickly facing market turbulence upon taking office is long-standing, although the actual data presents a more nuanced picture:
* Arthur Burns took office in February 1970 with the U.S. economy already in recession. * The aggressive rate hikes launched by Paul Volcker after his appointment triggered an economic contraction. * The Alan Greenspan era began in the aftermath of the 1987 "Black Monday" crash. * For Jerome Powell, the pandemic struck two years into his tenure.
Warsh takes over with the stock market at historic highs, having recovered swiftly from the initial shock of the Iran War. However, the bond market's "welcoming gift" may be the more genuine test for the new Chair.
Former President Trump's appointee, Powell, maintained a cautious stance on rate cuts, while Warsh has previously defended low-rate policies in a high-inflation environment.
Now, the bond market has already acted to show it does not intend to accommodate this stance.
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