Even a month ago, monetary policy sailing looked smooth for incoming Federal Reserve Chairman Kevin Warsh.
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One possible flare-up for Warsh, who became Fed chairman on May 22, succeeding Jerome Powell after an eight-year tenure, was the threat of the Iran conflict temporarily pushing oil prices higher. Yet in Warsh’s early days heading the nation’s central bank, inflation appeared contained. Even when the price of West Texas Intermediate crude spiked to over $112 a barrel in early April, the 10-year Treasury yield, a benchmark measure of future inflation expectations, remained muted, trading as high as 4.4% before cooling off.
For people who aren’t avid market watchers, bond prices were signaling that the Strait of Hormuz, which has been closed since late February, would reopen, letting 20% of the world’s oil supply flow freely again. Oil prices would ease globally, taming inflation, hence the perfect backdrop for interest rates to be cut as President Donald Trump has long demanded.
Here lies the major stumbling block for Warsh, who has telegraphed a willingness to slash the federal funds rate that his predecessor held constant: The seemingly moderate inflation of a month ago is no longer moderate. The bond gods can be cruel, and they have spoken.
As market expectations often do, they have turned on a dime. In the past two weeks, longer-term bond yields spiked, with the 10-year Treasury hitting 4.69% and the 30-year yield reaching 5.197%, the highest level in nearly 20 years.
As Bob Dylan once said, “You don’t need a weatherman to know which way the wind blows.” The bond market is now blowing loudly, and it believes that higher inflation is not going away. This deprives Warsh of an easy path to cut the federal funds rate.
Bond market warnings
If Warsh aggressively pushes for rate cuts to appease political pressure, despite rising inflation signals, he risks being perceived as a political puppet. More importantly, any move to the federal funds rate requires a majority of Federal Open Market Committee voting members, meaning he must persuade at least six of the other 11 members of the Board of Governors, the New York Fed president, and the rotating regional presidents.
Even if Warsh decides to slash rates and wins over enough votes, a decrease in the federal funds rate does not directly translate to a decrease in “interest rates” more broadly.
Trump’s relentless focus on lowering borrowing rates stems from the belief that more dovish monetary policy will bring down interest costs on anything under the sun, whether a family is mortgaging a new home or the federal government needs more cash to finance its $39 trillion national debt. While it’s true that the Federal Reserve can control ultra-short-term rates by setting the federal funds rate, we have a saying at my investment firm, Payne Capital Management, that the bond gods, not the government, control longer-term interest rates.
In other words, there are other forces at work that determine what the rate of our 30-year mortgage or car loan is going to be. For example, expectations of higher inflation can cause longer-term borrowing costs to rise, because lenders want to be compensated if future dollars are worth less. This longer end of the yield curve has moved increasingly independently of the central bank’s short-term rate machinations.
As someone who has invested money on behalf of clients for more than 25 years, I have learned two valuable lessons: (1) You can’t rely on one variable to define a trend; and (2) when it comes to the economy and investing, conventional wisdom is often wrong. Today, the consensus on Wall Street is that the reopening of the Strait of Hormuz will cause oil prices to drop precipitously, effectively cooling inflation expectations. Of course, it’s more complicated than that.
Even if there is a Middle East resolution that increases the supply of commodities, demand has been ramping up since the Strait of Hormuz was brought to a standstill. Industrial activity is picking up globally — think of the explosive focus on mining rare earth minerals, chip development, and the race for AI.
As the world produces more cars, airplanes, and electronics, demand is up not just from the pent-up backlog of oil, but also for industrial metals such as copper, aluminum, and nickel, which are skyrocketing. This is extremely inflationary. And while projected domestic economic growth is an unambiguous good — the Atlanta Fed projects second-quarter GDP growth of 3.8% — a hotter economy risks more demand-driven inflation in the absence of surging supply.
Furthermore, despite headlines warning that AI will corrode the labor market, April’s job report came in hotter than expected, with 115,000 jobs created as the unemployment rate sits at a historically low 4.3%. Meanwhile, baby boomers are retiring in droves as the share of seniors not in the labor force reached 50% in April.
The combination of steady job growth as the labor force ages and shrinks will put upward pressure on wage inflation. The point being, many factors will likely keep the inflation rate higher, not lower, as many Wall Street “experts” are predicting. This is exactly what the bond market is telling you today.
TOUGH NEWS FOR KEVIN WARSH IN FIRST FULL WEEK AS FED CHAIRMAN
It is between this rock and hard place that Warsh has walked into. In this environment, placating Trump and delivering a short-term rate cut in defiance of a bond market driving long-term rates higher could prove a Pyrrhic victory. Even if Warsh were able to convince a majority of voting Fed members to cut rates, ironically, that could push long-term rates higher.
That’s what happened when Powell prematurely slashed the federal funds rate in fall 2024, and ironically enough, that’s part of the reason Trump inherited the broader mortgage and Treasury environment he rightly reviled. The Fed chairman may have changed, but the bond gods will respond no differently if Warsh doesn’t learn from Powell’s mistakes.
Ryan M. Payne (@RyanPaynePCM) is the president of New York-based Payne Capital Management.
