Bond Market Signals Concern Over Kevin Warsh's Inflation Stance

Kevin Wash's market honeymoon period since taking office is fading. Long-term U.S. Treasury yields are hovering near their highest levels in nearly 19 years, as investors worry that he has not signaled a sufficiently hawkish stance, causing inflation risk premiums to re-enter the bond market.

The market honeymoon period following Kevin Warsh’s appointment as Fed Chair is coming to an end. Recent signals from the U.S. bond market indicate that investors want the Fed to adopt a clearer and more forceful stance on inflation.

On Thursday, U.S. long-term Treasury yields remained near their highest levels in nearly 19 years. The market was shaken the previous day after Waugh failed to convince investors during a press conference that he was willing to support further rate hikes to curb inflation.

This market volatility exhibits unusual characteristics: while long-term U.S. Treasury yields have risen, short-term U.S. Treasury yields have fallen, indicating investor concerns that the Federal Reserve may delay action and ultimately be forced to implement more aggressive rate hikes in the future.

For this new Fed chair, market reactions serve as a warning. After yields stabilized on Thursday, several investors and analysts said they still believe the Fed will ultimately adjust policy based on economic data—but if markets further doubt the central bank’s commitment to controlling inflation, the next round of bond selling could be more severe and may raise borrowing costs across multiple sectors, including mortgages and corporate bonds.

Christopher Sullivan, Chief Investment Officer of the United Nations Federal Credit Union, said that if economic data already indicates that the Federal Reserve needs to act, but the central bank still chooses to wait, “it would be a disaster for the long-term bond market.”

Over the past few years, bond investors have shown little obvious panic in response to challenges against the Federal Reserve's independence.

Trump previously pressured Powell, then-chair of the Federal Reserve, multiple times to cut interest rates. Under this pressure, U.S. Treasury yields did rise on several occasions last year, but the broader market did not react sharply.

At the time, many investors believed that the Federal Reserve’s interest rate decisions were made by a committee of 12 officials voting, and even though the chair held significant influence in the policy-making process, they might still be unable to secure consensus among the committee. Similar situations had also occurred at central banks in other countries, such as the UK.

At the same time, market participants believe that the Fed is unlikely to keep interest rates too low for long, given the potential negative reactions in the bond market.

Therefore, when Trump nominated Walsh for Fed chair in January, investors generally welcomed the move, viewing Walsh—as a former Fed governor—as potentially more policy-independent than other candidates, such as Kevin Hassett, director of the National Economic Council.

Wash’s press conference following his first policy meeting in June also satisfied investors, as he emphasized that Fed officials remained united and committed to bringing inflation back to the central bank’s 2% target. However, at this week’s press conference, investors sought clearer guidance on whether the Fed would raise interest rates this year if inflation pressures fail to continue easing.

However, Wash's remarks did not fully align with market expectations. He appeared to suggest that rate hikes may not be necessary, as bond yields have risen over the past few months. This disappointed some investors, as the earlier rise in yields had itself been interpreted as a signal that the market anticipated Fed rate hikes.

Wash also said that the Federal Reserve could look at additional inflation data beyond the official Personal Consumption Expenditures Price Index (PCE), and that raising interest rates is “likely” part of the solution to high inflation, but not the primary tool.

Wash's statements regarding the inflation assessment system further intensified market concerns.

“We will achieve a 2% inflation target, not a hair more,” Wosh said. “But to reach this goal, I am monitoring a broader set of inflation data than just the PCE.”

PCE has long been the Federal Reserve’s primary inflation indicator and a key basis for policymakers’ economic forecasts. Data released in the U.S. on Thursday showed that the PCE increased 3.7% year-over-year in June.

Wash said the Fed "will continue to use it," but added, "Who knows what we might say about our strategy after January next year."

He referred to multiple working groups he established, which are responsible for reviewing the Federal Reserve’s inflation framework and the economic data monitored by central banks.

“These remarks appear to confirm suspicions that these task forces are merely a fig leaf to redefine the inflation challenge,” wrote Michael Feroli, JPMorgan Chase’s chief U.S. economist, in a report to clients.

The market quickly responded. Investors in the $2 trillion inflation-linked U.S. Treasury market saw the 30-year breakeven inflation rate post its largest single-day increase since 2024.

This indicator reflects long-term market inflation expectations and is calculated as the difference between nominal Treasury yields and inflation-linked Treasury yields. Market participants view Wash’s comments on PCE and broader inflation metrics as one of the key factors driving this change.

JPMorgan strategists then advised clients to bet on rising inflation expectations through five-year forward five-year inflation swaps.

Former Richmond Fed president Jeffrey Lacker warned that Walsh needs to carefully choose the indicators to reference in the future.

“It’s completely unclear what indicators they will turn to, and more importantly, what criteria will guide their choices,” said Lacker, who was viewed by markets as an inflation hawk during his tenure as president of the Richmond Fed from 2004 to 2017.

You must choose a reliable, broadly representative index. There are only two: the PCE price index and the CPI. That’s it.

Currently, the June Consumer Price Index (CPI) increased by 3.5% year-over-year. This metric is used not only to measure changes in consumer prices but also to adjust Treasury Inflation-Protected Securities (TIPS) and Social Security cost-of-living adjustments.

Wash said he is not focused on just a single indicator. "Yes, I care about the PCE reading and the contributions from CPI and other data, but my perspective is broader than that."

However, the Federal Reserve Chair did not specify any other potential indicators that may be included in the analysis.

Kathy Bostjancic, Chief Economist at Nationwide Insurance, said, "It is crucial to define which inflation indicators he and the Federal Reserve will monitor."

Some Fed observers believe that, as future data are released, the broader indicators that Walsh is monitoring may show that inflation has not accelerated significantly.

“Over the coming months, broader inflation indicators that Walsh is monitoring should increasingly show that inflation is not accelerating in a concerning way,” economists Andrew Hollenhorst and Veronica Clark stated in their report on Thursday.

However, the Citi strategy team also warned that Wash’s policy stance could alter the trading range of the five-year, five-year forward inflation swap market. The team noted that this indicator’s upper bound has been capped at around 2.5% in recent years.

In addition, some investors believe that Walsh’s adjustment to the inflation framework could impact the U.S. Treasury market, which is valued at approximately $31 trillion, and push term premiums higher.

Jon Hill, Head of U.S. Inflation Strategy at Barclays, said that increased uncertainty about the Federal Reserve’s commitment to controlling inflation could push up term premiums and inflation risk premiums.

“When market uncertainty about the Fed’s commitment to fighting inflation rises or confidence declines, this translates into higher term premiums and higher inflation risk premiums,” he said.

However, some investors still believe the market need not be overly pessimistic. Although they were disappointed by Wash’s remarks, they noted that June’s inflation data already showed signs of cooling, and if this trend continues, the Fed may still not need to raise rates in September.

Interest rate futures data show that, on Thursday afternoon, traders expected a 63% probability of a Fed rate hike in September, down from 76% on Tuesday but higher than 56% on Wednesday evening.

Blake Gwinn, Head of U.S. Interest Rate Strategy at RBC Capital Markets, said that market sentiment could ease over the coming weeks as more Federal Reserve officials explain why no rate hike has occurred and what factors might prompt a policy shift.

“I think it would be positive for the bond market for the market to know that the committee is still in control, not any one individual,” said Gwinn.