Kevin Warsh may be the most hawkish Federal Reserve chair since Paul Volcker, and the bond market is treating that as more than a credential.
Thirty-year Treasury yields have climbed to their highest level since 2002. In September alone, the 10-year yield jumped more than half a percentage point, to about 5.3%. It was the worst month for U.S. government bonds in four years.
The usual market explanations do not fully account for a move of this size. The commentary points to technical factors such as a modest slackening in the so-called basis trade, where hedge funds buy fewer Treasurys to support leveraged bets. It also cites talk of a higher term premium and even an 'absorption premium'.
But those explanations are described as too small to explain what is happening in a $40 trillion market. The piece says the strategic backdrop remains inflation, deficits and geopolitics, and that those risks were not what re-priced in August or September.
Markets then priced a string of hikes, with an 80% chance of at least 100 basis points more than before Jackson Hole. 'Higher for longer' had become 'much higher for much longer.'
The memory of 2022-23 still hangs over traders. The Fed raised rates 525 basis points in 17 months. The Bloomberg Aggregate Index fell 13%. Treasurys lost 12.5%. The 10-year lost 16%, its worst return in a century. The iShares 20+ Year Treasury ETF lost 31.4%.
The damage was not confined to charts. Mark-to-market losses on 'safe' bonds helped kill Silicon Valley Bank and strained the banking sector. By mid-2023, banks carried almost $700 billion in unrealized losses, and $300-500 billion remains. Mortgage rates went from 3% to nearly 8%, and the housing 'affordability crisis' lingers.
The piece argues that traders now have a template for an aggressive Fed, and that they would rather overreact than underreact. It also says Warsh appears to view the selloff as the price of Fed credibility.
That is the tradeoff Washington always sells as discipline and others pay as pain. Consumers feel it in costlier auto loans and credit cards. Homeowners feel it in higher mortgage payments. Businesses face pricier credit. Banks absorb losses on 'safe' assets. Abroad, higher rates and a stronger dollar strain economies and currencies.
Capital rewards clear rules. It also punishes central bankers who treat credibility as a free good. The market has already voted on the price of that posture. The question now is whether the Fed thinks the taxpayer, borrowers and banks should keep paying it.
