Outlook for the U.S. Treasury market
I remain bearish on U.S. Treasuries. In my view, the U.S. yield curve ultimately needs to move materially higher and become steeper to attract sufficient capital to fund the fiscal deficit, amid competition from other sovereign issuers and the substantial financing needs associated with data center investment.
I do not expect this adjustment to take place in a straight line. Little or no forward guidance and a smaller Fed balance sheet are likely to mean greater volatility, making the path for yields uneven.
Momentum may also shift into the bond market. After momentum dominated other markets recently, there is a risk that the same dynamic could add to the pressure on bond prices and push yields higher.
Until the market receives the proof of Fed credibility it is seeking, I can see long-end yields rising in the short term. The move could be larger if the data come in hot or oil makes another run toward USD 100 per barrel.
At some point, I expect the market to force a response, creating an opportunity to add duration. The key question is how firmly the Fed chair remains committed to providing limited forward guidance as market pressure builds.
The Fed and market credibility
Going into the July FOMC meeting, I saw no chance that the Fed would raise rates and little basis for expectations of an immediate hike. The more important signal came from the price action around the meeting, particularly the sell-off in long-dated U.S. Treasuries
after the decision. Although a hold was the consensus, the reaction suggested to me that the bond market was demanding a more forceful demonstration of the Fed’s inflation-fighting credibility, with an immediate hike viewed as the clearest proof. In my view, confidence that the Fed can keep inflation expectations anchored is essential if the current Goldilocks environment is to persist.
Without clear forward guidance, it is difficult to identify what could act as a circuit breaker if the market continues to test the Fed’s resolve. Until investors receive a convincing proof point of the Fed’s credibility through policy action, economic data or clearer communication the long end of the Treasury curve may remain under pressure.
Warsh’s stated preference for a smaller Fed balance sheet and less forward guidance could increase both implied and realized volatility over the medium to long term. That volatility may initially emerge in rates before spreading into credit and potentially equity markets.
