As Kevin Warsh assumes leadership of the United States Federal Reserve, bond investors are betting he will prioritize the central bank's inflation-fighting credibility over President Donald Trump's push for lower interest rates. The shift in market expectations reflects the impact of the Iran war, which has unleashed the biggest inflation surge since 2023.
Rate Hike Expectations Surge
Traders are now pricing in that the Fed is virtually certain to start raising rates by December, a sharp reversal from just three months ago when markets anticipated deeper cuts. The change underscores the effects of Middle East turmoil, a resilient U.S. economy, and an AI-investment boom pushing stock markets higher, all fueling concerns that inflation could remain above the Fed's two per cent target.
Market Movements
In a volatile trading week, two-year Treasury yields—the most sensitive to Fed policy expectations—climbed to as much as 4.14 per cent on Friday, the highest in over a year and nearly 40 basis points above the top end of the Fed's benchmark rate range. Thirty-year yields briefly touched 5.2 per cent last week, a level last seen in 2007, before retreating to 5.06 per cent.
Warsh assumes leadership as a growing number of Fed officials abandon their easing bias. Governor Christopher Waller, a Trump appointee who earlier this year advocated for rate cuts to protect the labor market, said Friday that the Fed's next move is now just as likely to be a hike. A series of policymakers, including Vice Chair Philip Jefferson and New York Fed President John Williams, are scheduled to speak this week.
Warsh's Independence
As Warsh was sworn into office Friday, Trump, who has repeatedly pressured the Fed to lower borrowing costs, said he wants Warsh to lead the central bank independently. Some investors, including Chitrang Purani, a portfolio manager at Capital Group, are turning more bullish on short-term Treasuries as yields rise and rate hikes are priced in.
"I do believe that the bar to hiking rates is still reasonably high because this Fed and Warsh may want to be a little bit more patient before taking that next step to fully understand how inflation is translating into labor markets and financial conditions," Purani said. "I personally don't believe the Fed's reaction function to economic data will be materially different under Warsh than it was in the past."
In addition to reading tea leaves from Fed speakers, bond traders will also focus this week on auctions of two-, five-, and seven-year Treasury notes for signs of investor demand.
