The significant rise in US Treasury yields has to some extent served as a substitute for actual interest rate hikes, while Federal Reserve Chair Warsh's hawkish stance provides a clear anchor for this market pricing. A rare tacit understanding is forming between the bond market and the Fed.
The US Consumer Price Index (CPI) for June recorded its first monthly decline since 2020, offering the market a brief respite and prompting a rapid unwinding of bets on a Fed rate hike this month. However, Warsh promptly delivered clear remarks on Capitol Hill, stating that the June CPI data does not signify the inflation fight is over. Similar signals were subsequently issued by Kansas City Fed President Jeff Schmid, Dallas Fed President Lorie Logan, and Cleveland Fed President Beth Hammack.
Currently, traders' expectations for a July rate hike have largely dissipated, but there remains a widespread bet that the Fed will raise its benchmark rate by 25 basis points in September or October, with a hike before year-end almost seen as a certainty. Concurrently, the yield on the two-year US Treasury note has climbed approximately 75 basis points since late February to nearly 4.2%, significantly above the Fed's current policy rate target range of 3.5% to 3.75%. The rise in Treasury yields has effectively applied the brakes to the economy by pushing up mortgage and other borrowing costs.
Inflation Pressures Persist, Rate Hike Expectations Loom
Despite the brief relief from June's CPI data, market concerns about the inflation outlook have not dissipated. Following the breakdown of the US-Iran ceasefire agreement, oil prices have risen again; massive capital expenditure in the artificial intelligence sector continues to inject stimulus into the economy, even as bubble concerns emerge in some tech stocks. Inflation has remained above the Fed's 2% annual target for the past five years, a stubborn trend that makes it difficult for the market to confidently call for a policy pivot.
Columbia Threadneedle portfolio manager Ed Al-Hussainy stated, "If you do nothing, are you confident that inflation will fall back to 2% or 2.5%? The answer is no. The Fed should feel more confident about raising rates without being overly concerned about downside risks." He currently holds a position betting that long-term bonds will outperform short-term bonds, a strategy that would benefit from a more hawkish Fed policy path.
Economists at Bank of America anticipate the Fed will raise rates at its September, October, and December meetings. Following the release of the June CPI data, the bank noted in a client report that inflation remains well above target, and "we would need to see several more similar readings to reconsider our current call."
Market Does the "Heavy Lifting," Warsh Can Bide Time
The spontaneous pricing in the bond market is objectively sharing the Fed's policy burden. DoubleLine Deputy Chief Investment Officer Jeffrey Sherman pointed out that, based on federal funds rate futures pricing, the bond market has often moved ahead of the Fed in the past. The most significant change now is that the market is no longer consistently betting on rate cuts as it did over the past three years, but is instead starting to reflect the possibility of rate hikes within the next year.
Sherman noted this stands in stark contrast to previous policy cycles: "The market heard Powell announce the end of rate hikes and began expecting cuts, but those cuts never really materialized." Now, "the market seems to be saying: maybe the Fed will hike at some point in the next 12 months."
In his view, this means Warsh may not need to act immediately. "What you're seeing now is that the market has essentially done the Fed's job for it—the yield curve has a positive slope, and the policy rate is below all other rates on the curve. So, Chair Warsh may not need to do anything for now; he can wait and see," Sherman concluded, adding, "The bond market is doing its job; it's sniffing out the data."
Warsh's Hawkish Stance is Clear, But Deliberately Retains Flexibility
Warsh assumed the role of Fed Chair two months ago and has consistently prioritized lowering inflation since taking office. During his first post-meeting press conference last month, he repeatedly emphasized the necessity of controlling inflation; testifying before Congress last week, he reiterated that the June CPI data does not mean the mission is accomplished.
Notably, Warsh has not given clear signals regarding the timing of rate hikes and tends to downplay the Fed's forward guidance on the rate outlook, arguing that overly explicit guidance could box policymakers in and hinder their ability to adjust flexibly. Fed officials will enter their customary quiet period this week ahead of the two-day meeting starting July 28th, leaving the market without new policy signals during this time.
The Fed has remained on hold since its last rate cut in December. At that time, the job market was recovering from its February trough, coupled with a new wave of inflationary shocks from the Trump administration's military actions against Iran, which dashed the market's widespread expectation for the Fed to resume rate cuts. Warsh has clearly stated his commitment to upholding the Fed's political independence and not yielding to pressure from Trump for rate cuts.
Market Divisions Remain, Caution Prevails
Despite rate hike expectations dominating the market, some institutions hold a more cautious view on the actual pace of Fed action. Chi Chen, co-manager of BlackRock's $18 billion Total Return Fund, stated, "The market's pricing of the Fed's policy path is more hawkish than we would expect, assuming our view of moderating inflation and slowing growth in the second half is correct. The Fed will likely maintain a hawkish stance and wait for the data to finally soften." Her team currently favors intermediate and short-term bonds, believing that after the post-Iran war sell-off, "valuations are clearly more attractive than before."
Sherman also expressed reservations about the threshold for a September hike, believing it would require "a lot of data" to force the Fed into that decision, especially with an election approaching and political pressure still present.
Al-Hussainy was more direct: "Now is not the time to stick your neck out." With the policy path still unclear, avoiding heavy bets on Fed-sensitive positions might be the safest choice for now.
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