Inflation "nuclear bomb" looming over, US bond "Powell trade" logic quietly changing.

Not long ago, investors in the US Treasury market were confident in the "Powell trade": simply betting that Kevin Warsh, the incoming chairman of the Federal Reserve, would cut interest rates multiple times after taking office. But now, with only a few days left until Warsh officially takes over the Federal Reserve, market views have changed. Against the backdrop of a strong US economy and geopolitical conflicts driving inflation concerns, the $31 trillion US bond market has begun to shift towards betting on monetary policy tightening. Currently, the 30-year US Treasury yield is approaching the 5% mark, and the steepening of the yield curve trade based on loose expectations has largely faded. It is reported that earlier, the market was betting that Warsh, after taking over as the chairman of the Federal Reserve, would push for rate cuts to lower short-term yields, while also raising long-term yields through balance sheet reduction, thereby forming a steeper yield curve pattern in US Treasury yields (i.e. "steep trade"). Now, investors do not believe that Warsh has suddenly abandoned his policy of rate cuts and balance sheet reduction. Instead, they are realizing that this chairman-elect, who has been ridiculed by some as a "puppet on a string" of Trump, will ultimately be constrained by changing economic conditions, just like all previous Federal Reserve chairs. "The economic events will dictate his policy choices, not ideology," said Adam Marden, co-manager of global bond strategy at T. Rowe Price. The fading of the "Warsh trade" has made the already complex bond market even more difficult to grasp. The Iran situation has caused significant fluctuations in oil prices, becoming a key disruptive factor for short-term interest rate trends. Despite concerns about inflation heating up, the threshold for both raising and lowering interest rates by the Federal Reserve remains high, exacerbating internal disagreements within the Federal Reserve. Meanwhile, artificial intelligence has boosted economic growth and increased market risk appetite, making the bond market trends even more complex. Priya Misra, portfolio manager at J.P. Morgan Asset Management, said, "This market is very difficult to trade and analyze. Artificial intelligence is creating capital spending, bond supply, and boosting optimism about long-term growth prospects in the US. At the same time, we are experiencing the largest shake-up in the energy sector in history." Will the "inflation bomb" explode tonight? The market may underestimate the possibility of Fed rate hikes. Despite the increased difficulty in analyzing market trends, many investment banks still offer predictions for future paths. Strategists at Bank of America pointed out that the market is currently significantly underestimating the potential for Fed rate hikes, as the probability of rate hikes increased further after the strong employment report in April. One of the trading strategies recommended by Bank of America strategists is betting that the yield on two-year US Treasuries will rise. This judgment is similar to the views of Marden from T. Rowe Price. Marden's global fund is short on US Treasuries, betting that the Fed will maintain a tightening monetary policy in the face of economic resilience and rising price pressures. Warsh has said that the increase in productivity brought about by artificial intelligence can suppress inflation and lead to lower interest rates. However, Marden said, "If the Consumer Price Index (CPI) reaches 3.5% by September, he won't talk about productivity anymore." Investors are closely watching the US CPI report to be released on Tuesday to assess the Fed's policy determination in a high oil price environment. Economists expect the index to rise by 3.7% year-on-year, reaching a new high since 2023. A "hot" CPI report could completely change expectations. Jordi Visser, managing director of AI Macro Nexus at 22V Research, pointed out that the report "may not just confirm another unsettling inflation data." He believes that the trend over the past two months looks more like a repeat of the 2022 inflation surge, rather than the "de-inflation" narrative that the market has long believed in. Interest rate swap trading shows that traders believe that the likelihood of the Fed raising rates before April 2027 is close to 60%. This is a stark contrast to the situation before the outbreak of the Iran conflict at the end of February, when traders expected multiple rate cuts. Some strategists believe that even in a complex market environment, Warsh will try to shape his own policy style. Analysts at Morgan Stanley said that under Warsh's leadership, the Fed may shift to new inflation indicators, reduce policy forward guidance, and accelerate balance sheet reduction, which could significantly increase volatility in the US bond market. Could the "Warsh trade" make a comeback? However, some analysts firmly believe that the "Warsh trade" will eventually return, with the core logic being that a weak economy or cooling inflation will restart rate cut expectations. The yield on the 10-year US Treasury is currently at a high level, pushing up costs for car loans and mortgages, which will suppress the economy; if oil prices remain high for a long time, the downside economic risks will further increase. Ed Al-Hussainy, portfolio manager at Columbia Threadneedle, said, "The window for the return of the Warsh trade lies in a significant weakening of the labor market. We are not in such an environment now, but it could become a reality before the end of the year." Based on this, Andrew Szczurowski, investment manager at Morgan Stanley, is positioning himself to be long on short-term US Treasuries. He believes that the Fed will eventually cut rates to stabilize employment, and the recent adjustment in US Treasuries is a good buying opportunity. Szczurowski said, "I still believe that most Fed officials believe the next policy action will be a rate cut. Whether it lands in 9 months or 12 months, it's no problem."