Investors HATE Kevin Warsh

The new fed chairman is having a difficult time gaining trust

The Market Is Losing Faith in the Fed

The bond market is starting to send a message that investors should probably pay attention to.

The Federal Reserve says it wants to bring inflation down.

The market does not seem convinced.

That disconnect is showing up most clearly in long-term Treasury yields. The 10-year yield is pushing toward levels that have not been seen in years, while the 20-year and 30-year parts of the curve are already above 5%.

At the same time, the Fed is holding short-term rates steady and continuing to buy short-duration Treasuries.

So we have a strange situation.

The Fed is trying to control inflation while also supporting liquidity at the short end of the market.

Meanwhile, investors are demanding higher returns to lend money for longer periods.

That matters because the 10-year Treasury is basically the foundation underneath a huge portion of the financial system.

Mortgage rates.

Corporate borrowing.

Auto loans.

Business financing.

Government debt.

When the 10-year yield rises, the cost of money rises across the economy.

And right now, the long end of the bond market is telling the Fed something very different from what policymakers want to hear.

The Fed Says Inflation Is The Problem

The Federal Reserve has become much more aggressive in its language around inflation.

The message is basically that inflation needs to come down, and the Fed is committed to price stability.

That sounds reassuring.

The problem is that markets care about actions more than speeches.

You can tell investors that inflation is the enemy all day long.

If investors believe inflation will remain elevated for years, they are going to demand compensation for it.

Think about a 30-year loan.

If you expect inflation to average 4% over the next three decades, lending money at 3% makes little sense. You are effectively losing purchasing power while taking on the risk of lending.

So lenders demand more.

Maybe 5%.

Maybe 6%.

The exact number changes with expectations and risk, but the basic idea remains the same.

Long-term interest rates are heavily influenced by what investors think inflation will look like in the future.

And that is why the recent rise in long-term yields matters so much.

The market appears to be saying:

We don’t fully believe you can get inflation under control.

The Fed Is Holding Short-Term Rates Steady

The Fed has kept the federal funds rate around the 3.5% to 3.75% range.

Normally, you might expect tighter policy to push borrowing costs higher across the curve.

But something unusual is happening.

The short end is relatively stable while the long end keeps moving higher.

That is creating a steepening yield curve.

And there is a reason for it.

Short-term rates are much more closely connected to Fed policy.

The Fed can directly influence the price of short-term money.

The long end is different.

It is heavily influenced by investors, pension funds, banks, foreign buyers, institutions and everyone else deciding whether they want to own long-term US government debt.

The Fed can influence this market.

It cannot completely control it.

That distinction is becoming increasingly important.

The Fed’s Balance Sheet Is Growing Again

Here is where things get even more interesting.

The Fed’s mortgage-backed securities holdings continue to decline.

That sounds like quantitative tightening.

But at the same time, its Treasury holdings are increasing.

The Fed has been taking principal payments from its mortgage-backed securities and using that money to purchase Treasury bills.

It is also buying short-term Treasury securities to maintain what it considers an ample level of reserves in the banking system.

So the balance sheet is growing even while mortgage-backed securities continue to roll off.

This creates a weird policy mix.

The Fed is allowing one part of its balance sheet to shrink while expanding another.

And from the market’s perspective, buying assets is still buying assets.

The official explanation may be reserve management.

But the practical effect is that liquidity is being added at the short end of the Treasury market.

That matters because it helps explain why short-term yields are behaving differently from long-term yields.

The Fed has more influence over one side.

The market has more influence over the other.

And the market appears to be pushing back.

The Yield Curve Is Telling Us Something

Imagine two different markets.

One market is heavily influenced by the Federal Reserve.

The other is being driven more by investors trying to figure out what inflation, government borrowing and economic growth will look like over the next decade or two.

The first market is relatively calm.

The second is becoming increasingly nervous.

That is basically what we are seeing.

The long end of the Treasury curve is rising because investors want more compensation for holding long-term debt.

And that creates a strange situation where the market itself starts doing some of the Fed’s tightening.

If 10-year yields rise, mortgage rates tend to rise.

Corporate borrowing gets more expensive.

Businesses think twice before financing new projects.

Consumers become less willing to borrow.

Housing becomes less affordable.

Investment becomes harder.

So even if the Fed refuses to raise short-term rates, higher long-term yields can still tighten financial conditions.

There is just one problem.

Higher rates do not only destroy demand.

They can also destroy production.

The Side Effect Nobody Talks About

The standard argument is simple.

Higher interest rates reduce borrowing.

Less borrowing reduces spending.

Less spending reduces demand.

Lower demand eventually brings inflation down.

But there is another side.

Businesses need financing to expand.

A company might have a profitable project that requires $500 million of capital.

If borrowing costs are low, the project makes sense.

If financing costs suddenly jump, the project may no longer be profitable.

So the company cancels it.

Now production does not increase as much as it otherwise would have.

The same thing happens throughout the economy.

Higher rates can reduce demand.

But they can also reduce investment and production.

That creates a nasty problem for policymakers.

If inflation is being driven partly by supply constraints, destroying demand does not necessarily fix the underlying issue.

It can simply make the economy weaker while prices remain elevated.

That is one reason this environment is so difficult for the Fed.

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The Fed Wants Less Communication

There is another issue making investors uncomfortable.

The Fed has signaled that it may communicate less frequently.

That could mean fewer scheduled meetings or fewer press conferences when there is nothing meaningful to announce.

The argument is straightforward.

Why constantly tell markets what you might do next?

Let the market respond to actual economic conditions instead.

In theory, that sounds reasonable.

In practice, it creates another problem.

The Federal Reserve is not just another participant in the market.

It sets the price of short-term money.

Its decisions influence almost everything else.

So telling investors to stop anticipating the Fed while the Fed continues to control a major part of the pricing mechanism creates an obvious contradiction.

You cannot tell markets to freely discover prices while simultaneously controlling one of the most important prices in the entire economy.

That is the price of money.

And when investors do not know what the central bank is going to do, volatility increases.

Interest Rates Are The Price Of Money

This is the bigger philosophical issue.

Interest rates are essentially the price of capital.

When the Fed changes interest rates, it changes the cost of borrowing across the economy.

That affects everything from mortgages to corporate debt.

So when the Fed changes rates, it is not making one isolated decision.

It is influencing millions of economic decisions happening simultaneously.

That is why every Fed meeting receives so much attention.

Markets are trying to figure out what the people controlling the price of money are going to do next.

And uncertainty around that creates volatility.

If the Fed communicates less while remaining extremely influential, investors have to make bigger guesses.

Those guesses get priced into bonds, stocks, currencies, commodities and credit markets.

The Inflation Numbers Matter Too

There is another reason investors may be skeptical.

The way inflation is measured can produce very different answers depending on which measure you use.

The Fed has increasingly pointed toward alternative measures such as trimmed-mean inflation.

The idea is to remove extreme price movements from the calculation.

That can be useful.

But it can also produce an inflation number that looks better than what consumers feel.

If prices are rising across a broad range of goods and services, removing the extremes does not necessarily make the underlying inflation problem disappear.

It just changes the measurement.

That creates a perception problem.

If households feel that everyday costs are rising faster than the official numbers suggest, confidence in the statistics starts falling.

And markets are not immune to that skepticism.

The Most Interesting Possibility

Here is where things get counterintuitive.

A surprise rate hike could potentially cause long-term yields to fall.

At first, that sounds impossible.

If the Fed raises rates, shouldn’t bond yields go higher?

Not necessarily.

The short end would probably rise.

But if investors suddenly believe the Fed is serious about fighting inflation, expectations could change.

Investors might conclude that inflation will be lower in the future.

That makes long-term bonds more attractive.

Demand for long-term Treasuries rises.

Prices rise.

Yields fall.

So you could theoretically get a situation where a rate hike at the short end causes long-term yields to decline.

That would essentially be the bond market saying:

Okay, now we believe you.

The problem is that the Fed has not shown that it wants to take that route.

And the longer investors remain unconvinced, the more pressure builds in the bond market.

Something Eventually Has To Give

This is the part worth watching.

When 20-year and 30-year Treasury yields are above 5%, the US government is dealing with a very different interest burden than it was when borrowing costs were close to zero.

The United States already has an enormous amount of debt.

Higher rates mean refinancing that debt becomes increasingly expensive.

And the problem compounds over time.

Existing debt matures.

It gets refinanced.

The government issues new debt.

Investors demand higher yields.

Interest expenses increase.

That requires even more borrowing.

Then the market has to absorb even more Treasury supply.

It becomes a feedback loop that policymakers cannot ignore forever.

At some point, something has to change.

Maybe inflation falls.

Maybe economic growth collapses.

Maybe the Fed becomes more aggressive.

Maybe long-term yields stabilize.

Maybe some part of the financial system breaks first.

The exact trigger is impossible to know.

But the current setup is not sustainable indefinitely.

The Market Is Voting

The most important takeaway is simple.

Do not focus only on what the Federal Reserve says.

Watch what the bond market is doing.

The Fed can announce that it wants price stability.

It can hold meetings.

It can publish projections.

It can change the federal funds rate.

But ultimately, investors decide what they are willing to accept for holding long-term debt.

And right now, they are asking for more.

That is the warning.

The market is not completely buying the Fed’s inflation story.

Short-term rates are relatively controlled.

Long-term rates are moving higher.

The Fed’s balance sheet is growing again through Treasury purchases.

Communication may become less frequent.

Inflation expectations remain uncertain.

And the government is facing a massive refinancing problem at exactly the moment when borrowing costs are becoming more expensive.

That combination is dangerous.

It does not automatically mean a crash is coming tomorrow.

It does mean the bond market is becoming increasingly important to watch.

Because if the long end keeps rising, the Fed may eventually be forced to respond.

And when that happens, the biggest question will not be whether the Fed can control short-term rates.

It will be whether investors still trust the Fed enough to lend the US government money cheaply for the next 10, 20 or 30 years.

Right now, that trust is being tested.

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