ROI-The bond market isn’t buying what Fed Chair Warsh is selling: McGeever

The US bond market's surge to a two-decade high indicates investors have lost faith in Federal Reserve Chair Kevin Warsh's ability to combat inflation.

The plunge in long-dated U.S. bond prices reveals two things about how investors view Federal Reserve Chair ​Kevin Warsh: his honeymoon period is over, and his inflation-fighting credibility is under serious scrutiny. The 30-year Treasury yield surged above ​5.20% on Wednesday, the highest in two decades. The move snowballed in the wake ‌of Warsh's press ​conference rather than immediately after the central bank's decision to keep interest rates on hold, a sign that bond investors were unimpressed with his plans – or lack thereof – to get inflation back to the 2% target, which it has been above for five years and counting.

This was Warsh's second post-meeting press conference after replacing Jerome Powell two months ago. He was given a pass at his first ‌policy meeting in June, but since then he has expressed an unwavering commitment to end the era of above-target inflation, so the bar this time was much higher. The bond market's verdict? He failed to clear it.

As the 30-year yield leaped to its highest point since 2007, yields at the short end of the curve fell, a sign that investors are less certain the Fed will raise rates at its next meeting. Indeed, rates futures pricing now suggests that the likelihood of a hike in September has fallen to around 55% from a near certainty ‌earlier on Wednesday. When the yield curve steepens primarily because of a sharp rise in long-dated yields, it is often a sign that bond investors believe the Fed won’t act aggressively enough to bring down inflation and thus fear that inflationary expectations could become ‌unanchored. No Fed Chair can allow that perception to take root among investors, consumers, or businesses – especially not one who took office under a cloud of suspicion about his independence from a White House that has explicitly called for more dovish policy.

That would be playing with fire, but Warsh appeared to stoke the flames on Wednesday. CLEAR AS MUD

Warsh has stated that he thinks the Fed should communicate less, and perhaps he should take his own advice. His messaging was so muddled and convoluted that it left investors even more confused and anxious. The Fed's 2% inflation goal is based on the Personal Consumption Expenditures (PCE) price index. That’s a fact, not an opinion, yet Warsh ⁠was surprisingly equivocal ​when asked what 2% measure the Fed is specifically targeting.

"I'll give two ⁠answers. First, let me give the proper, standard answer. The Federal Reserve every January outlines a statement of purposes and strategy. And in that strategy document ... it describes the measure of PCE inflation as the objective function there. That's our number, we're sticking with it." But Warsh indicated it might be different next January, once the various task ⁠forces he is setting up come back with their findings. The second part of his answer was woolly, at best, raising legitimate concerns about his commitment to the 2% target.

"When we talk about measures of inflation, and we describe those measures as being consistent with our objectives, we might make them such ​that they're not very good measures or very good objectives. ... I'm looking at a broader set of inflation data than PCE. "So without fully revealing my cards, I'm trying to understand, like my colleagues, what's the underlying, generalized change in prices that ⁠are happening in the economy. It's not a perfect science. We (are) .. trying to look and see if we can separate the noise from the signal. Yes, I care about what the PCE prints are, I care about what the contributions are from CPI and everything else, but my lens is broader than that, even though the remit is ⁠quite ​narrow."

Warsh also revealed little about how the return to price stability would be achieved. He indicated that markets have been doing some of the Fed's work for it, given the rise in bond yields in the six weeks between the June and July policy meetings. But why yields are rising matters. If market-based rates are being driven upward by Fed credibility doubts, relying on this kind of tightening is a risky strategy. A bond rout could force the Fed to tighten more aggressively than it otherwise would have to restore its credibility. ⁠So, if this selloff continues, expect Fed officials to ramp up the inflation-fighting rhetoric - Wall Street's slump on Wednesday and the recent rise in U.S. mortgage rates to the highest level in a year highlight the risks otherwise. Warsh took a gamble when he ⁠eliminated forward guidance, especially during an uncertain period for the inflation outlook. Muddying ⁠the waters around the Fed's 2% inflation target is a gamble too. The bond market is flashing red that neither will pay off. As Oscar Munoz at TD Securities wrote on Thursday, "(Warsh's) honeymoon period has ended with a bang."

(The opinions expressed here are those of the author, a columnist for Reuters) Enjoying this column? Check out Reuters Open Interest (ROI), your essential new source for global financial commentary. Follow ‌ROI on LinkedIn, and X.

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