A yield flattening - in which the spread between short-term and long-term yields narrow - suggests bond traders believe the Fed will start containing inflation
Kevin Warsh is getting the market reaction every new Fed chair hopes for: Not necessarily a rally, but a market that trusts his words.
Kevin Warsh passed another big test as a new Federal Reserve chairman on Friday: He said the central bank still has work to do on inflation, and the bond market took him at his word.
But here's the issue: Inflation hasn't been the thing driving a sharp selloff in long-term government debt lately, so Warsh may have just won a fight that the Treasury market wasn't really having in the first place.
In his first speech at the annual Jackson Hole Economic Policy Symposium on Friday, the new Fed chair said that high levels of inflation in recent months remain concerning. Warsh added that he would be "hard-pressed" to describe broad financial conditions as restrictive - meaning interest rates weren't high enough to slow economic growth.
The market took him seriously, with fed-funds futures traders ratcheting up bets of an interest-rate hike as soon as next month's Federal Reserve meeting - with the chances of a hike jumping to nearly 60%, from just above 30% earlier in the week, according to the CME FedWatch Tool. Warsh's remarks also eased some of the bond market's skepticism about his commitment to lowering inflation after he kept policy rates steady last month.
The yield on the 2-year Treasury note BX:TMUBMUSD02Y was up 12 basis points (0.12 percentage point) to 4.352%, a five-week high, while the 30-year rate BX:TMUBMUSD30Y remained mostly unchanged at 5.207%, according to FactSet data.
The moves - depicting a "yield-curve flattening" in which short-end rates surge while long-end rates don't rise nearly as much - suggest that markets are taking the Fed chair's hawkish stance seriously, pricing in higher-for-longer interest rates in the near term while betting those tight policies will successfully cool inflation over the long term, even at the cost of slower economic growth.
Also notably, the spread between the 2-year and 30-year Treasury yields was at about 87 basis points on Friday afternoon, putting it on pace for its lowest level in a month, according to FactSet data (see chart below).
"Traders want to see commitment from the Fed after a couple of [Federal Open Market Committee] meetings where they weren't too sure how to read the new chair," said Eric Wallerstein, chief macro strategist at Clocktower Group. "It's important that the Fed does their job - but at the end of the day, long-term borrowing costs are not set by the Fed."
Indeed, while Warsh's remarks did inject a vote of confidence into how the bond market thinks the Fed will handle inflation, consumer prices haven't been the main force behind this month's run-up in Treasury yields, especially at the long end. In other words, Warsh didn't really address the problem that's actually been driving longer-term yields to two-decade highs.
Bond yields and prices move in opposite directions. Growing worries that the U.S. government's growing debt - which recently crossed the record milestone of $40 trillion - and its massive deficit have been the dominant reasons for the recent selloff in long-duration, 10-year BX:TMUBMUSD10Y to 30-year Treasury debt. A flood of long-term corporate bonds from tech "hyperscalers" to fund their AI data-center build-outs has been making the problem worse, as they directly compete with the U.S. government for investor capital - pushing long-term bond yields higher.
"The long end is still much more influenced by factors outside of the Fed's control: How is the economy doing? What does the fiscal outlook look like? Is there more hyperscalers' issuance coming?" Wallerstein said in a phone interview Friday. "The Fed is not the only and certainly not the most important variable right now driving long-term borrowing costs."
But a hawkish-sounding Fed chair isn't enough to guarantee inflation will be firmly on a path lower through more restrictive monetary policy, said Kathleen Brooks, research director at XTB. "I still think that market moves on the back of this speech could fade quickly if the economic data does not swing hawkish, because Warsh is not a proponent of forward guidance," she told MarketWatch.
Another weak labor-market report next Friday could easily dim hopes of a September rate hike, Brooks added.
A big unknown coming out of Warsh's remarks is how the Fed will manage its balance sheet. Warsh is leading a review to reduce the central bank's roughly $6.7 trillion to $6.8 trillion balance sheet, aiming to lower asset holdings while avoiding disruptions to funding markets.
"He was silent [on Friday]. ... We've seen Treasury Secretary Bessent try to bring down longer interest rates as part of a buyback program," said Chris Gunster, head of fixed income at Fidelis Capital. "Warsh's view is to reduce Fed impact, reduce government impact in longer-end rates. I believe that if he had addressed balance-sheet policy going forward by the Fed, it would have been in conflict with the actions of the Treasury."
The Treasury Department is issuing trillions of dollars in new debt to finance its $1.8 trillion fiscal deficit. If the Fed were simultaneously shrinking its balance sheet through quantitative tightening - by reducing its holdings of Treasurys and leaving the market to absorb a larger share of both new Treasury issuance and securities rolling off the Fed's balance sheet - that could put further upward pressure on long-term Treasury yields.
As a result, Warsh sort of pushed the matter of the balance sheet off to the side, Gunster noted.
U.S. stocks were mostly lower on Friday afternoon. The Dow Jones Industrial Average DJIA was nearly flat, while the S&P 500 SPX was off 0.2% and the Nasdaq Composite COMP was down 0.5%, according to FactSet data.
-Isabel Wang
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