The Federal Reserve initiates the "Powell era": a change in leadership but not in the script of inflation. The US bond market is on high alert for the "5% era".

Investors are preparing to face a longer period of high US bond yields. They doubt whether the incoming Federal Reserve Chairman, Kevin Wash, will be able to tame the inflation caused by the soaring oil prices resulting from the long-term Middle East conflict. With rising energy prices putting pressure, investors are demanding higher compensation for inflation risks, and long-term yields, including the benchmark 10-year US bond, have surged. The rise in long-term yields will directly transmit to the borrowing costs of the entire economy: mortgages, corporate bonds, and leverage loans all become more expensive. Senate vote has twists and turns The Senate on Wednesday voted through Kevin Wash's nomination as Federal Reserve Chairman by a narrow margin. This opens the most controversial leadership transition at the US central bank in decades and will test its political independence. The vote on Wednesday of 54-45 is the narrowest margin in the history of the confirmation of a Federal Reserve Chairman, reflecting the polarization of Congress and concerns among Democrats that Wash may yield to President Trump's prompt to cut interest rates. Hours before the Senate vote, worries over accelerating inflation were exacerbated by a government report on wholesale prices. The Producer Price Index (PPI) rose 6% year-on-year in April, exceeding all expectations from the survey of economists conducted by Bloomberg. The core wholesale inflation index, excluding food and energy, rose by 5.2%, indicating that the war-driven rise in energy costs is spreading to other goods. The prolonged inflation caused by the oil price shock triggered by the Iran war poses a challenge for policymakers. Consumer price data released on Tuesday showed a rapid increase in gasoline, groceries, rent, and airfare prices in April. The core issue overshadowing the incoming chairman is: as the majority of the Republican Congress led by Trump faces a midterm election test in less than six months, can he maintain the tradition of the Federal Reserve making rate decisions free from political pressure? Wash pledged at the nomination hearing that under his leadership, the Fed's monetary policy would remain "strictly independent." But Trump, who has repeatedly criticized Powell for not lowering rates quickly enough, has made it clear that he expects Wash to immediately lower borrowing costs. An increasing number of Fed officials believe that the institution should send a clear signal that the Fed's next rate move could be either a cut or a hike. For Wash, this means that if he tries to guide the Fed to cut rates that officials believe are unjustified, he will face fierce resistance. Wash also hinted that he would seek to gradually reduce the Fed's $6.7 trillion balance sheet over time, arguing during the hearing that rate cuts are fairer than expanding the balance sheet, as the benefits of rate cuts are more inclusive. He criticized the Fed's performance in countering inflation during the Biden administration, implying that the Fed had lost focus on its core mission. Powell announced in April that he would remain on the Federal Reserve board after his term as chairman ends but will maintain a low profile. He said the reason for this departure from recent precedent is the continued criminal investigation threats against him and the central bank, which jeopardize the Fed's independence. Wash's debut may face tough inflation "threats" Christian Hoffman, head of fixed income at Sandberg Investment Management, said, "It is not an exaggeration to say that ongoing and above-target inflation has been unsettling for almost five years... and there is still no clear direction for investors to feel at ease and reassured." Rising benchmark yields may also pose resistance to the US stock market as companies and consumers face higher borrowing costs. This could also drag down corporate profits while potentially making bond yields more competitive compared to stocks. The surge in yields is closely related to the energy market, with investors seeing it as the main driver of price pressure. Byron Anderson, head of fixed income at Laverne & Company, said, "The trend of oil determines the direction of yields." This situation has prompted some investors to reduce their exposure to long-term bonds. Anderson said his company has almost completely avoided long-term bonds. He believes that ongoing inflation will continue to drive up long-term yields, potentially pushing the 10-year Treasury bond yield closer to 5%, a level unseen since October 2023. Since early March, the benchmark 10-year yield has risen by about 45 basis points and hit an 11-month high on Wednesday. The yield is currently at 4.484%. Divisions within the Federal Reserve Investors say stubborn inflation will challenge Wash, who may face a decision-making group with divergent views. Ryan Swift, chief US bond strategist at Montreal BCA Research, said, "If the first thing we hear from Wash is... a dovish tone about how the Fed will cut rates, I think that will be a big problem for the bond market." "That really would have the risk of inflation expectations breaking out and causing the long end of the curve to get out of control, which would be a big problem." Financial markets are not expecting the Fed's policy rate target of 3.5%-3.75% to change this year. Jim Baird, chief investment officer at Plante Moran Financial Advisors, said, "As Wash prepares to take office, there are indeed some challenges ahead of him. The challenge surrounding the inflation situation is that there are many factors... that cannot simply be resolved by raising rates idealistically. Raising rates will not lower global oil prices." Yield curve expected to steepen Some believe that the future yield curve will steepen, reflecting market expectations that short-term rates at the near end of the curve will remain stable while oil-driven inflation will trigger selling of long-term US bonds. As investors have ruled out the possibility of rate cuts this year due to stubborn price pressures, the steepening trend had stagnated at the start of the Middle East conflict. However, the curve has steepened in the past two trading days, with the spread between the 10-year and 2-year yields recently at 48.50 basis points. Chip Houchi, managing director of fixed income at Truist Wealth, he said, although there is still debate over the Fed's next move - easing or tightening - sticky inflation reinforces the expectation that rates will remain unchanged until inflation pressures ease. Houchi expects the curve to steepen, predicting that the Fed will eventually transition to rate cuts later this year. This will suppress short-term yields, while long-term yields will remain high due to ongoing inflation and economic resilience. Anderson of Laverne & Company believes that a steepening curve is reasonable. "I think you'll continue to see long-term bonds being sold off because you'll continue to see inflation rising." Wash's long-term policy inclinations, especially his focus on shrinking the Fed's balance sheet and potentially shortening the maturity of its portfolio, could also reshape the curve. A smaller Fed balance sheet means less demand from the government for US bonds. In a financial environment where central banks do not provide liquidity to the market, conditions will tighten. The Fed's reduction in bond purchases will also increase the supply of US bonds, which often leads to lower bond prices and higher long-term yields, making the curve steeper. Martin Tobias, US rate strategist at Morgan Stanley, said the market is still trying to understand how Wash may handle balance sheet policies, which could ultimately affect term premiums and the dynamic of US bond supply. However, any change could be gradual. "Wash will need some time to build consensus," said Tobias.