What High Bond Yields Are Telling the Fed

The Federal Reserve held rates steady on Wednesday, but I expect to see its resolve tested in the coming months. Three Fed presidents voted for a rate increase, and long-term bond yields are at their highest level in nearly two decades.  

The Fed’s statement was unchanged from June, and I believe Chair Kevin Warsh’s comments at the press conference revealed little. When coupled with the Fed’s inaction, Warsh’s comments caused the markets to stop asking questions and start demanding action.

Most notable to me during the 45-minute press conference was the many times Warsh remarked that markets had stopped watching the Fed and instead are now pricing in real changes in the underlying economy. With long-term bond yields rising during Warsh’s remarks, the market is pricing not only tighter financial conditions through a steeper yield curve, but also a lack of confidence this Fed has what it takes to deliver on its mission. Warsh seemed almost proud that yields rose more during this intra-meeting period than 90% of intra-meeting periods over the last two decades.  

The Fed’s primary policy tool is setting short-term rates; longer rates simply reflect the market’s expectations for short rates over the medium to long term. Markets are indicating that the Fed will have to raise rates more in the future by foregoing action today. I’m not sure I’d tally this in the policy-win column for Warsh.  

Markets historically have tested new Fed chairs, and this seems to be a repeat of the past.  I believe the Fed is on the cusp of a policy mistake; they cannot continue to suggest a 2% target yet fail to react when data suggests they are unlikely to hit their target.  

My belief is we will see action. I continue to think the Fed is looking for cover to raise rates, and one month of benign inflation failed to deliver that cover. Unless we expect inflation surprises to the downside soon (I don’t), a rate hike is in the cards.

Additionally, we believe there could be notable change in Fed communication, and its mix of policy tools. The five new committees and a Fed chair looking to do things differently will certainly provide alternatives to the status quo.

I expect volatility will remain elevated, and I believe this Fed is not seeking to mute that volatility, but rather seems to be celebrating it. A question we must begin to ask is how much longer the real economy can hang on in the face of a series of shocks to the consumer.

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