The Fed Reveals Its Cards and Long-Term Rates Begin to Calm

Forward guidance is back. The Fed has once again provided guidance on its future actions. Although its chairman, Kevin Warsh, has not yet spoken up. However, silence implies consent. Other officials have spoken. John Williams, as so many times before, was the initial spokesperson; Philip Jefferson; Christopher Waller. The central bank will raise rates again, but there is no urgency. The first part was known, the second was the central topic of discussion. Desperation is evident throughout the yield curve. And Warsh, who canceled the Fed's communication of intentions in advance, placed the bonds in the atrium to express themselves loudly and without interference. "I want to hear their message without filters," he said in July. Not anymore. Williams, Jefferson, and Waller sang the "no more" tune. Is it a revolt? No. It is a conspiracy orchestrated with Warsh's blessing to rescue him from the tantrum of the bonds. The chairman participates with his absolute silence. As can be seen, not all innovations are successful.

Forward guidance has returned and tells us that the urgency of the bonds is not theirs. Will the bond vigilantes calm down this way? That is the idea, that they do not get scared of their own shadow that keeps growing. In September, the Fed broke Warsh's umbilical cord with the White House. It raised the fed funds rate after nine months of crossed arms. It did so six months later than the first bullish bucking of the curve. It was a unanimous decision and proposed by Warsh (who blocked it in July). Late, but sure. President Donald Trump spoke before the meeting with the chairman as Richard Nixon did with Arthur Burns in the 1970s. The decision came about the same, although he did not like it one bit. It is early to issue a verdict, but Warsh, from the sidelines, begins to resemble Jerome Powell more than Burns.

How much does the transition in the Fed influence the persistent obscurity of the bond curve? How does the transfer of power from Powell to Warsh, under the constant pressure of the White House, affect it? A lot, if high-frequency data is observed. Little to nothing if the analysis is extended. The gaffe in July -- when the newly appointed chairman could not explain the decision, nor even the Fed's reaction function -- was corrected in Jackson Hole. In September, the decision was changed. And it was aligned with the hawkish discourse that Warsh has fed since his first day.

How much did those ups and downs influence the constant rise of long-term rates? Believe it or not, in the end, nothing. The credibility of the central bank was only scorched at its edges. Just a coat of paint. The chassis was not damaged. The inflation expectations incorporated by the bonds in their quotes did not shift. Despite the endless war and the rising cost of energy and inflation itself. This has been repeated here to exhaustion. The rate hike is a hike in real interest rates. The nominal rate for ten years climbed 121 basis points in the last year. The real rate explains 118. Inflation over the last twelve months rose 70 basis points (according to the August measurement of the personal consumption deflator). Expected inflation over ten years, just three. At 30 years, the real rate grew 94 basis points and the nominal, 98. In other words, only four additional points are attributable to the inflation premium. Conclusion? It’s the economy, stupid, James Carville would say. It’s a booming economy where the temperature of AI weighs more and more. That a new chairman and the markets do not get along in their first year of management is the rule and not the exception. Afterward, coexistence adjusts. There is no reason to think it cannot be this way. Warsh did not destroy anything that cannot be tidied up.

What can the Fed do, nonetheless, to ensure that nothing significant breaks with the frenzy of long-term rates? That is the role of forward guidance, to maintain peace. "It is a useful tool when needed... I can't think of anything that constitutes more of a forward guidance than what happened last week," said Governor Chris Waller, referring to the comments from Williams and Jefferson. Although Waller requests that it not be called that. "Signaling" would be its new name (which would also prevent Warsh from having to retract). Williams and Jefferson indicated that a cycle of interest rate hikes has begun. Without urgency. Based on what the data dictates. Waller added signals: there is flexibility in the timing of adjustments. "It is not necessary for them to occur in consecutive meetings, but they must be implemented within an acceptable timeframe (for a quicker return of inflation to the 2% target)." As we mentioned last week, a path of three rate hikes, one per quarter, with a meeting in between, is a predictable itinerary. September, December, and March would be the vaccination dates. Fed funds would return to its September 2025 level. It should not be the death of anyone. It would pressure inflation downward and relieve bonds from having to (pre)occupy themselves. It would also create space to incorporate the increase in real rates that AI promotes with the vigor of its expansion.

The Fed showed its cards, and long-term rates began to moderate. First, of course, there was the need to pass the test of the ten and thirty-year bond auctions. The tantrum in fixed income did not subside until it was confirmed that both operations were very successful. Two and a half times oversubscribed, investor demand (direct and indirect) took 94% and 88%, respectively, of what was offered. It did so at a yield below that prevailing in the market. It was also a signal: rates continued to fall afterward. At ten years, they closed at 5.24%. Still in the danger zone, but 13 basis points lower than the fleeting peak on Wednesday.

The bull market turns four years old today. The Fed gifted it, with the unofficial "signaling," an uphill but predictable roadmap that is appreciated. Bonds, with their persistent tantrum, could not ruin the preparations. The Nasdaq -- and the Nasdaq 100 -- have been accumulating records for two weeks. The S&P 500 stalled on Friday just millimeters away. However, the party is not complete. The guest list has been trimmed to a handful. But attendance will expand if long-term rates calm down. Whether due to the Fed's guidance, Bessent (who will want to trim the quarterly refinancing agenda), or the intention to hedge AI risk with credit-risk-free bonds. And the party will be even bigger if September's inflation cooperates.

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