Surging U.S. Treasury yields are doing part of the Federal Reserve’s work for it, tightening financial conditions even before any new rate move. That has left the bond market and the Fed unusually aligned: investors are pushing rates higher on their own, while Chair Warsh’s hawkish messaging is reinforcing that pricing.
June U.S. consumer price index data, which showed the first monthly decline since 2020, gave markets brief relief and prompted traders to unwind positions tied to a July hike. Warsh quickly pushed back on the idea that the inflation fight was over, telling lawmakers on Capitol Hill that one month of softer CPI did not complete the task. Kansas City Fed President Jeff Schmid, Dallas Fed President Lorie Logan, and Cleveland Fed President Beth Hammack have delivered similar messages.
July odds fade, but later hikes remain in view
Traders have largely dropped expectations for a July increase. Even so, markets still broadly price in a 25-basis-point hike in either September or October, and many investors now treat another move before year-end as highly likely.
The bond market has already moved. Since late February, the two-year U.S. Treasury yield has risen by about 75 basis points to nearly 4.2%, far above the Fed’s current 3.5% to 3.75% target range. Higher Treasury yields have fed into mortgage rates and other borrowing costs, putting a real brake on the economy.
Inflation concerns have not gone away
One softer CPI print has not erased concern about the inflation outlook. The original report said oil prices moved higher again after a U.S.-Iran ceasefire agreement broke down. It also pointed to heavy capital spending tied to artificial intelligence as another source of stimulus for the economy, even as some technology stocks have already drawn bubble concerns. Inflation has stayed above the Fed’s 2% annual target throughout the past five years, making it difficult for markets to lean too quickly toward a policy pivot.
Ed Al-Hussainy, a portfolio manager at Columbia Threadneedle, said: “If you do nothing, are you confident inflation goes back to 2% or 2.5%? The answer is no. The Fed should feel more confident hiking and not be overly worried about downside risks.” He is positioned for long-dated bonds to outperform short-dated ones, a trade he said would benefit from a more hawkish policy path.
Economists at Bank of America expect the Fed to raise rates at its September, October, and December meetings. After the June CPI release, the bank said in a client note that inflation remained well above target and that it would need to see several more similar readings before reconsidering that call.
The market may already be doing the tightening
Some investors argue the bond market’s repricing is taking pressure off the central bank. Jeffrey Sherman, deputy chief investment officer at DoubleLine, said fed funds futures have often moved ahead of actual Fed action. This time, he said, the key change is that markets are no longer spending the way they did over the past three years by persistently betting on rate cuts. Instead, they have begun to reflect the possibility of hikes over the next year.
Sherman contrasted that with the earlier policy cycle: “The market heard Powell say hikes were over and started expecting cuts, but the cuts never really came.” Now, he said, “the market seems to be saying maybe the Fed hikes at some point in the next 12 months.”
In his view, that gives Warsh room to wait. “What you’re seeing now is that the market has effectively done the Fed’s job for it — the yield curve has a positive slope, and the policy rate is below every other rate on the curve. So Chair Warsh may not need to do anything right away and can sit back and watch.” Sherman added: “The bond market is doing its job. It’s sniffing out the data.”
Warsh stays hawkish but keeps his options open
Warsh took over as Fed chair two months ago and has made lower inflation his top priority since taking office. At his first post-meeting press conference last month, he repeatedly stressed the need to bring inflation down. In testimony last week, he repeated that June CPI did not mean the mission was finished.
He has not, however, given a clear signal on the timing of any future rate increase. The report said Warsh prefers to downplay strong forward guidance on the rate path, arguing that guidance that is too explicit can box policymakers in and limit flexibility. Fed officials are set to enter the customary blackout period ahead of the two-day meeting that begins on July 28, leaving markets without fresh policy signals for a time.
The Fed has been on hold since its last rate cut in December. According to the report, a rebound in the labor market from its February low, combined with a new inflation shock tied to military action by the Trump administration against Iran, led markets to abandon what had been widespread expectations for the Fed to restart easing. Warsh has also said he will defend the Fed’s political independence and will not yield to pressure from Trump to cut rates.
Investors are not fully aligned on the pace
Even with rate-hike expectations dominating market pricing, some large investors are more cautious about how quickly the Fed will actually move. Chi Chen, co-manager of BlackRock’s $18 billion Total Return Fund, said: “The market is pricing a more hawkish Fed path than we expected, assuming our view of lower inflation and slower growth in the second half is correct. The Fed may stay hawkish and wait for the data to soften.”
Her team currently prefers intermediate- and short-dated bonds and sees valuations as more attractive after the selloff that followed the Iran war.
Sherman is also hesitant about the bar for a September hike. He said it would take “a lot of data” to force the Fed into that decision, especially with elections approaching and political pressure still present.
Al-Hussainy was more blunt: “This is not the time to stick your neck out.” With the policy path still unsettled, avoiding oversized positions tied closely to Fed sensitivity may remain the safer trade for now.