Bond Traders Flying Blind on Fed See Risk Yields Spiral Higher

(Bloomberg) — Bond investors including Brandywine Global Investment Management and Wellington Management say the risk of a deeper Treasury rout is rising as Federal Reserve Chairman Kevin Warsh keeps investors in the dark about how officials will respond to the evolving economy.

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The Treasury market is signaling that Warsh’s inflation-fighting credibility is eroding after he declined to outline how he plans to curb price pressures when policymakers left interest rates unchanged last week. The flow of information may even dry up further: On Friday, the New York Times reported that he’s considering reducing the frequency of the central bank’s scheduled policy meetings.

In the absence of guidance around how officials will react to economic figures such as this week’s monthly jobs data, the market is demanding a greater premium on longer-dated debt. Traders have piled into options bets that yields on longer maturities will keep climbing.

The result is steeper borrowing costs for the government, homeowners and companies. The rate on the 30-year Treasury, the maturity that’s most vulnerable to inflation angst, is at a 19-year high. Meanwhile, German bond yields have hit a 15-year high on inflation worries, and long-term rates have risen in Japan as well.

“It’s dangerous to step into the long end of the curve,” said Tracy Chen, a portfolio manager at Brandywine. She’s holding less US bond exposure than her benchmark. “If inflation in the next two months stays high and the Fed doesn’t hike in September, the bond vigilantes will go nuts.”

For now, traders see a roughly 70% chance that the Fed will tighten at its next meeting in September. For October, the month before the pivotal US midterm elections, a hike is fully priced in.

The conflict in the Middle East has lifted oil prices, sparking inflation concerns and complicating officials’ ability to chart policy. But as the Iran war drags on, investors are fretting that higher inflation expectations may become entrenched.

Three Fed officials who dissented against the decision to hold rates steady warned on Friday that waiting too long to act against inflation could risk the need for more aggressive policy moves later.

While Warsh has pledged to restore price stability, his ambiguity on several key issues has raised doubts about his commitment. He argued that higher bond yields are already doing some of the Fed’s work in tightening financial conditions, questioned whether the Fed’s preferred inflation gauge remains the right target and suggested that interest rates aren’t the only tool for curbing inflation.

Warsh raised the proposal to change the frequency of meetings at last week’s gathering of the Federal Open Market Committee, the New York Times said. A Fed spokesperson declined to comment.

“This does not come as a total surprise given Warsh’s focus on changing the way the Fed communicates with markets and the public,” said Ben Emons, managing director of fixed income at Highline Asset Management and founder of FedWatch Advisors. Still, it would be “a bit of a bombshell” and “it will induce volatility.”

Also, “fewer meetings means markets will keep having to do the heavy lifting,” he said.

Curve Signals

Warsh last week made it clear he isn’t planning to spoon-feed investors signals on where policy is headed and that he’s willing to ride out any market volatility.

“Surprises are not the objective,” he said in his post-decision press conference. “But at the same time, I would say we didn’t come into this meeting feeling constrained by the full range of alternatives we had in front of us.”

Shifts in the Treasuries yield curve encapsulate how, in the eyes of investors, there’s been some erosion in the policy credibility of the central bank.

In the wake of the June Fed meeting, Warsh’s first as chairman, the gap between short- and longer-dated yields narrowed swiftly when the market heard a very clear message from officials — getting inflation down to a long-run target of 2% was the chief policy objective. A flatter curve is one way the market signals faith in bringing inflation lower over time.

Last week, however, investors flipped that script. They aggressively sold longer-dated bonds, leading to a marked steepening in the yield curve, a signal of intensifying inflation angst amid frustration over the lack of a policy framework from officials.

Options trading last week featured buying of 10-year contracts targeting a yield move to around 4.9% by Aug. 21, which would be the highest since 2023, from a bit above 4.7% now. Other bets look for a 30-year yield above 5.4%, around their peak in mid-2007. The long bond touched as high as 5.28% last week.

“The range in Treasuries is now elevated and we’re back to 10-years heading towards 5%,” said Kevin Flanagan, head of investment strategy at WisdomTree. “At some point if the data continues to point in the direction of tightening, you can’t just talk the talk, you are gonna have to walk the walk.”

Fiscal Backdrop

Concern around the US fiscal outlook is also pressuring yields higher. Investors are also looking to this week’s announcement of Treasury auction sizes for the August-to-October quarter. While the Treasury is expected to hold those amounts steady, the possibility that officials will lay the groundwork for increases next year is helping drive up long-term yields, strategists said.

For Brij Khurana, a portfolio manager at Wellington, US long-dated yields are trading at “an attractive level.”

However, he worries “that once the market starts to question Fed credibility, that’s why yields are moving higher,” and he prefers owning inflation-linked bonds in the five-year area.

This week’s data crowned by the July employment report looms as a test of how far the market can shift expectations for Fed policy when there’s no guidance.

“The Fed does have a risk of losing control of this bond market,” said Scott Dimaggio, head of fixed income at AllianceBernstein. While higher yields look attractive, “the bond market is going to have trouble finding its footing,” unless Warsh articulates his framework to curb inflation, he said.

What Bloomberg strategists say…

“While more immediate questions over the Fed’s inflation-fighting credentials are powering yields higher in the short term, the growth story — driven by $2 trillion of future spending by AI hyperscalers — stands to be a stronger anchor for bond markets longer term.”

— Alyce Andres, macro strategist, Markets Live. For the full analysis, click here.

What to Watch

Economic data:
- Aug. 3: S&P Global US manufacturing PMI; ISM manufacturing index; construction spending; Omdia total vehicle sales
- Aug. 4: Trade balance; factory orders; JOLTS jobs openings; durable goods orders; capital goods orders
- Aug. 5: MBA mortgage applications; ADP employment change (July); S&P Global US services and composite PMIs; ISM services index
- Aug. 6: Initial jobless claims; Challenger job cuts; nonfarm productivity; unit labor costs; wholesale inventories and trade sales
- Aug. 7: Nonfarm payrolls for July; NY Fed 1-year inflation expectations; consumer credit
Fed calendar:
- Aug. 4: Kansas City Fed President Jeff Schmid
- Aug. 5: Governor Lisa Cook; San Francisco Fed President Mary Daly
- Aug. 6: St. Louis Fed President Alberto Musalem
- Aug. 7: Richmond Fed President Tom Barkin
Auction calendar:
- Aug. 3: 13-, 26-week bills
- Aug. 4: 6-, 52-week bills
- Aug. 5: 17-week bills
- Aug. 6: 4-, 8-week bills