The Federal Reserve's credibility is facing scrutiny as the bond market takes the lead in influencing interest rates. Market observers, including Wall Street veteran Ed Yardeni, suggest that the Fed's hawkish rhetoric without corresponding action diminishes its authority. This situation arises as the central bank remains divided on its next steps to combat inflation, with three dissensions noted in its latest meeting to keep interest rates unchanged at 3.50% to 3.75%. The market's uncertainty is further exacerbated by Fed Chair Kevin Warsh's shift away from holding investors' hands through forward guidance, placing more onus on economic data interpretation.
Several factors are pushing bond yields higher, including rising inflation expectations and a general steepening of the yield curve. The yield on inflation-sensitive 30-year U.S. bonds has risen to 19-year highs, and the 10-year yield saw its largest monthly increase since March, climbing by nearly 27 basis points in July. This trend is seen by some as the bond market effectively doing the Fed's work, tightening financial conditions on its behalf without direct intervention. Analysts also point to rising gilt and JGB yields as part of a global upward trend.
The "hawkish hold" by the Fed, characterized by maintaining rates while signaling potential future hikes, has created a challenging environment for both stocks and bonds. This approach keeps upward pressure on yields, particularly for policy-sensitive maturities like two-year Treasuries, as investors demand higher compensation. While some view this as Warsh allowing the market to find appropriate levels for interest rates and inflation, others worry about increased market volatility and the potential for sharper bouts of tightening if the Fed delays action further. Markets had priced in a 77% chance of a September rate hike before pulling back to about 57%.
