Warsh Shows His Hawkish Claws, and the Bond Market Believes It: U.S. Treasury Yield Curve Flattens as Rate-Hike Bets Heat Up Across the Board

The bond market is showing growing confidence that Federal Reserve Chair Kevin Warsh will deliver on his promise to rein in inflationwhich has now exceeded policymakers' target for five consecutive years. After the Fed raised borrowing costs on Wednesday for the first time since 2023 and predicted further tightening, traders now expect three more rate hikes by the middle of next year, one more than anticipated before the decision was announced. Interest-rate swaps show the first increase could come as early as next month. The repricing pushed two-year Treasury yields to their highest level since 2024, reflecting the view that the Fed is willing to impose meaningful tightening to slow the economy and bring inflation down. That could prove a headwind for U.S. stocks, which have already fallen in response. Though Warsh was careful not to pre-commit to any future moves, his remarks emphasizing dissatisfaction with the inflation trajectory clearly conveyed the Fed's policy intent. That contrasts sharply with the market's reaction to the Fed's decision to hold rates steady in July, when Warsh's vagueness on his plan to reduce price pressures triggered a selloff in long-term bonds. "We're moving from concerns about the Fed's credibility to focusing on the economic impact of the Fed zeroing in on bringing inflation back to target," said Priya Misra, a portfolio manager at JPMorgan Asset Management. The two-year Treasury yieldthe tenor most sensitive to Fed expectationsclimbed to 4.74% from 4.6% before the Fed statement. Longer-dated Treasuries, which are more sensitive to inflation, laggeda sign investors expect officials to act to contain price pressures. Meanwhile, long-term inflation expectations fell sharply. At the post-meeting news conference, Warsh reiterated his concerns about inflation, saying recent data "doesn't tell me that the underlying trend has improved materially." In a separate statement, the Fed said the hike "will support a more timely return to the Committee's 2% objective"referring to its inflation target. "This was a credibility-test meeting for Warsh," said Jeffrey Rosenberg, a senior portfolio manager at BlackRock. "The market is treating this as a much more credible Fed chair." With inflation above the Fed's 2% target for more than five years, traders had priced in a better than 90% probability of a Wednesday hike. According to compiled data going back to 2008, whenever rate-hike expectations have reached such high levels, the Fed has delivered without exception. Those expectations began building last month after Warsh said the Fed would ensure inflation cools "quickly enough." They were largely cemented after data last week showed core inflation rose more than expected in August. Meanwhile, U.S. job growth surged and the unemployment rate held steady, providing evidence of solid labor-market momentum. "The Fed is essentially telling the market: the economy is stronger, the labor market is tighter, inflation is proving more persistent, and policy needs to stay tighter for longer to restore price stability," said Daniel Siluk, a portfolio manager at Janus Henderson Investors. The divergence between short- and long-term Treasuries flattened the yield curve, with the gap between two-year and 30-year yields narrowing to its tightest level on a closing basis since March 2025. That further reinforces the trend of Fed decisions and Warsh's remarks repeatedly jolting the bond market. Since Warsh took the helm of the Fed in May, the three largest single-day swings in that yield-curve measure have all occurred after his appearances: following his two previous post-meeting news conferences in June and July; and after his speech at the Fed's annual symposium in Wyoming in August. To be sure, while the Fed on Wednesday went some way toward easing investors' concerns about its commitment to fighting inflation, it will still need to follow through if price pressures remain elevated. For now, the market is pricing in even more rate hikes next year than the most hawkish Fed officials project. Ahead of Wednesday's decision, 10-year and 30-year Treasury yields had surged to their highest levels since 2007. The move higher was part of a global rise in yields since the U.S. and Israel launched strikes on Iran in Februarywhich disrupted Middle East energy supplies and sent oil prices soaring. Other forces are also pushing yields up, such as a wave of corporate borrowing to fund artificial-intelligence (AI) spending, which is flooding the market with debt and injecting stimulus into an already resilient U.S. economy. "With supply and demand shocks, destroying demand through higher interest rates is the only way to fight inflation," said Luigi Buttiglione, chief executive of advisory firm LB Macro. "It's hard to see how bonds and stocks can withstand this headwind."