Federal Reserve Chairman Kevin Warsh effectively cut the rope connecting Treasury yields to central bank policy in June, and markets are starting to realize the gravity of that decision.
Myriad central bank actions-including artificially low interest rates, balance sheet activities, and direct market intervention during pandemic, banking, and fiscal crises-have kept a massive thumb on the scale of bond markets for much of the past two decades.
That thumb has lifted gradually over the past few years, and was released nearly all at once when Warsh began his tenure at the Fed this spring.
"There has been a tendency, and I take plenty of blame for this, to suppress volatility and spoon-feed markets," Warsh said during a central banking symposium in Sintra, Portugal earlier this summer. He vowed to reduce the amount of direction provided by the Fed, leaving investors to their own views on growth, inflation, and employment.
Guiding markets was "the right policy for a crisis," he added. "It is not the right policy for the time we have now."
The result has been stark, with benchmark 10-year note yields rising to the highest levels in more than a year and quickly approaching the 5% level, 30-year Treasury yields trading at the highest since the global financial crisis, and fixed income markets around the world moving toward a full autumn meltdown.
Or, maybe, a full market normalization.
The fact is that stocks, and indeed the broader financial world, will need to adjust to a free-moving bond market that's no longer tethered to the step-by-step guidance of the Fed, or possibly the implicit backstop it's provided for much of the new millennium.
That's been evident in both the surge in nominal yields, which have added a staggering 47 basis points to 30-year bonds since the end of June, as well as the rise in real yields, which are the component of yields not tied to inflation.
"The biggest move in recent weeks and months has been the ratcheting higher in real yields," says Padhraic Garvey, regional head of Americas research at ING. Supply pressures, both in terms of government bonds sales, as well as the rush to issue new debt from the world's biggest tech companies, are huge factors.
But Garvey is seeing something else as well.
"Actually, it's real yields moving back to more sensible levels, and a reversion to normal rates," he says. "To the type of levels that we saw before the craziness of the great financial crisis and pandemic years that trampled them to the floor."
Whether this "new normal" is one where rates remain disengaged from the Fed, or whether the dynamic spirals into a broader form of bond market vigilantism, remains to be seen.
The man who first coined the term, designed to describe investors who sniff out government largess, corporate profligacy, geopolitical tremors, and inflation risks long before other financial assets, isn't worried yet.
"We aren't pushing the panic button," says Wall Street veteran Ed Yardeni, founder and president of Yardeni Research. "However, we are closely monitoring whether the bond vigilantes might do so."
He still sees 10-year notes trading in range of between 4% and 5%, levels he thinks "won't cause any adverse consequences for the economy and corporate earnings." But he is keeping a sharp eye on markets as the 5% threshold looms.
And without the Fed's support, that threshold might get met sooner rather than later.
Overall U.S. debt has exploded over the past decade, and is only days away from topping the $40 trillion mark. This year's deficit is likely to top $2 trillion, with another $2.1 trillion expected in the coming financial year.
Inflation, while softening somewhat over the summer, remains firmly above the Fed's 2% target. Simmering tensions in the Gulf region are likely to stoke another rise in global crude prices that will take consumer prices even higher into the autumn.
Bond markets have asserted their independence from the Fed in the past, of course, most notably in the fall of 2024.
That period saw traders add around 100 basis points to 10-year yields over a four month period, even as the central bank lowered its benchmark lending rate by the same amount, as the economy's tech-led resilience defied the Fed's ambitions.
What's happening now might be more permanent. In fact, JPMorgan analysts estimate that within the next five years, interest, entitlements, and other "mandatory outlays" will permanently exceed tax revenue, just as overall debt levels top $50 trillion. Bond markets will need to reconcile that crossover, and fast.
"For much of the last fifteen years, investors operated in a market where stable-to-falling interest rates consistently supported higher stock prices," says Anthony Saglimbene, chief market strategist at Ameriprise. "But the landscape is shifting."
This is what Warsh said he wanted. The question is how much higher rates have to rise before he rethinks his strategy.
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