Yields move higher as Fed limits guidance
Chair Warsh and markets begin a complicated dance.
In the period since May 22 when new Federal Reserve (Fed) Chair Kevin Warsh took office, the weighted average yield of the US Treasury index has risen 14 basis points (bps). Already on record about his plan to reduce the Fed’s forward guidance, Warsh’s July FOMC press conference suggests he is also reluctant to elaborate on current policy action as well, instead reiterating points he has made about FOMC commitment to hash out differences and remain firm against inflation.
The contradictions between Chair Warsh’s oft-repeated pledges to address elevated inflation and his failure to explain the conditions that would prompt policy tightening are sowing doubt about his inflation-fighting resolve. Making matters worse, his suggestion that market players set interest rates while the Fed occupies the role of referee rather than the key player with sole control of the monetary base and target interest rates fueled confusion about how Warsh intends to direct monetary policy.
Meanwhile, the US economy continues to expand—driven by strong consumer spending and business investment—and inflation remains elevated amid the oil-price volatility from the conflict in the Persian Gulf. This swirling combination has contributed to higher US Treasury yields in recent weeks.
Financial and international conditions have also contributed to rising US yields. Strong corporate earnings have kept equity markets near record highs, boosting wealth effects for high income households. Meanwhile, heavy current and future debt issuance to finance the AI build-out amid persistently large US federal borrowing needs suggests equilibrium interest rates must remain elevated to attract capital.
On the international front, the European Central Bank and the Bank of Japan (BOJ) seem biased towards higher policy rates in response to upside inflation risks and surprisingly resilient growth in their respective economies. In addition, recent coordinated foreign exchange intervention by the BOJ and the US Treasury to support the beleaguered Japanese yen may produce only a temporary effect that must be followed by the BOJ further hiking rates.
What forces may prompt a stabilization or even partial retracement for US Treasurys? Treasury yields are now comparable to those that prevailed in the early 2000s before the Global Financial Crisis. Such elevated yields may continue to attract strong investor flows into bond funds and may prompt institutional rebalancing from surging equities into fixed income. The coming US midterms may induce risk asset volatility due to rising policy uncertainty. Recent US inflation indicators have surprised to the downside as tariff related pressures ease, and China’s slower growth and rising trade surplus represent a disinflationary impulse to much of the rest of the world. Lastly, any progress towards deescalation in the conflict with Iran should produce some drop in oil prices.
Though the balance of risks favors further increases in Treasury yields, the Federated Hermes Duration pod currently maintains a neutral position. Upcoming inflation and jobs data, events in the Persian Gulf conflict or further communications from the Federal Reserve may create an opportunity to enter a tactical short at more attractive levels.
Read more about our current views and positioning at Fixed Income Perspectives