Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / The Fed Holds at 364 as Bond Market Tests Kevin Warsh
Transcript
- Lucas: So Kevin Warsh gets sworn in as Fed chair this Friday, and the bond market is already sending him a welcome basket—a ten-year yield at four-point-five-nine percent and a core PCE deflator that is still running above target. Luna: Yeah, the timing is pretty remarkable. The effective fed funds rate is sitting at three-point-six-four percent, which is where it's been since April, but the market is starting to price in a real chance of a hike in July. Lucas: Right. And the person making that case most loudly is Ed Yardeni—the same strategist who actually coined the term 'bond vigilantes' back in the early 1980s. He told CNBC just this week that the Fed will have to raise rates in July to appease the vigilantes. Luna: I love that term—bond vigilantes. It sounds like a graphic novel, but it's really just a colorful way to describe investors who sell bonds when they think policymakers are being too loose. Lucas: Exactly. And Yardeni revived it during the 2023 bond sell-off, but the concept goes back to the 1990s. Back then, vigilantes pushed yields higher because they feared the Clinton administration's fiscal policy would reignite inflation. It worked—the bond market essentially forced policymakers to tighten. Luna: So what's different this time? The Fed has already hiked aggressively. We're at three-point-six-four percent on the effective fed funds rate. The ten-year is at four-point-five-nine. That's not exactly easy money. Lucas: No, it's not. But look at the inflation data. April CPI came in at three-three-two-point-four—up from three-three-zero-point-two-nine in March. Core CPI also ticked higher. And the core PCE price index for March was one-two-nine-point-three, up from one-two-eight-point-nine. The progress on inflation has stalled. Luna: And the breakeven inflation rate—that's the market's implied expectation for inflation over the next decade—has actually dropped to two-point-four-four percent. So the bond market is saying inflation expectations are well-anchored, but the actual inflation prints are sticky. Lucas: That's the tension. The vigilantes aren't panicked about inflation expectations unraveling—they're worried about the Fed being too slow to react to sticky data. Yardeni's argument is that if the Fed doesn't hike in July, the long end of the curve will do the tightening for them, and that could be more disruptive. Luna: So the playbook is: preempt the vigilantes by raising rates now, even if the data doesn't scream 'overheating,' rather than risk a violent sell-off later. Lucas: Precisely. And that puts Warsh in a tough spot. He's walking into his first FOMC meeting as chair in June—well, technically he's not chair until Friday, so the June meeting will be his first. Does he signal a July hike right away, or does he let the data play out? Luna: Historically, new chairs tend to avoid big surprises early on. They want to establish credibility, not rattle markets. But Warsh is not a traditional pick—he's been a Fed governor before, but he's also been a vocal critic of some of the post-2008 policies. Lucas: Right. He was a Fed governor from 2006 to 2011, so he was inside during the financial crisis. He's seen the machinery up close. But since then, he's been in the private sector and writing op-eds. He's known as a hawkish voice, so the market might expect him to lean toward tightening. Luna: But if he hikes in July, that's going to draw political heat, especially in an election year. The White House has been fairly quiet about the Fed recently, but a rate hike right before the midterms—that's a different story. Lucas: Yeah, and the Fed's mandate is dual: price stability and maximum employment. Unemployment is still low—around three-point-eight percent—so the employment side isn't screaming for accommodation. But the political pressure could be intense. Luna: Let's talk about the curve. The two-year yield is at three-point-five-eight percent—that's the three-month T-bill proxy—and the ten-year is at four-point-five-nine. So the curve is steep, which normally signals that the market expects growth and inflation ahead. But if the Fed hikes, that could flatten the curve. Lucas: That's the classic vigilante dynamic. If the Fed doesn't hike, the long end rises because investors demand a term premium for inflation risk. If the Fed does hike, the short end rises and the curve flattens. Either way, financial conditions tighten. The question is which path is less damaging. Luna: Yardeni is essentially saying: better to have the Fed do it in a controlled way than to let the market do it chaotically. Lucas: And that's the argument Warsh is going to have to weigh against the risk of overtightening. The lag effect of monetary policy is long and variable. The hikes we've already done are still working through the economy. If the Fed hikes again in July, they could overshoot and tip the economy into recession. Luna: So what's your read? Will Warsh hint at a July hike in the June meeting, or will he keep the door open but wait for more data? Lucas: I think he'll keep the door open. He's too smart to box himself in during his first meeting. But the language will shift—I expect the statement to note that 'inflation remains elevated' and that the Committee is 'prepared to adjust policy as needed.' That's code for 'we might hike in July.' Luna: And the market will parse every word. The bond market has been on edge for weeks. The five-year yield is at four-point-two-six—basically flat over the week—but the ten-year has come down a bit from its highs. Lucas: The ten-year actually dropped one-tenth of a percent over the last five days, which is interesting. It suggests that some of the vigilante pressure has eased, maybe because the market is starting to believe the Fed will act. Luna: Or maybe because Warsh's appointment is seen as hawkish enough that the market is giving him the benefit of the doubt for now. Lucas: That's a real possibility. The market is forward-looking. If investors believe Warsh will be more aggressive than Powell was, they might be less inclined to sell off long-term bonds preemptively. They wait to see what he actually does. Luna: So the vigilantes are in a 'show me' mode, not 'shoot first' mode. Lucas: Exactly. And that gives Warsh a bit of breathing room. But if the April PCE data—which comes out next week—shows another sticky reading, the pressure will ratchet up fast. Luna: We should also note the international context. The UK just signed a trade deal with Gulf states, and there's news about Putin and Xi reviving a gas pipeline. Geopolitics can affect energy prices, which feed into inflation. Lucas: Right. Energy is a wildcard. If oil prices spike because of the Iran situation, that could push headline CPI higher and make the Fed's job even harder. Core inflation might be sticky, but headline is what voters feel. Luna: One more thing—the AI economy is getting a lot of play as a disinflationary force. Some argue it could boost productivity and keep prices down over the long run. Lucas: That's a longer-term story. For the next six months, it's about the data in hand. And the data in hand says inflation is not yet defeated. Luna: If today's episode was useful to you and you want to keep it ad-free, buy me a coffee dot com slash fexingo helps. Lucas: Yeah, it's a small thing that makes a big difference for us. Appreciate it. Luna: So, back to the rate path—do you think the bond vigilantes will get their July hike, or will Warsh blink? Lucas: I think Warsh will deliver it, but only if the data cooperates. If April PCE comes in hot, he'll have cover. If it's soft, he might wait until September. The key is he doesn't want to be seen as bowing to the vigilantes—he wants to be seen as data-dependent. Luna: But the vigilantes are watching the same data. If the Fed doesn't hike in July and inflation stays elevated, they'll sell bonds and force the Fed's hand anyway. Lucas: Exactly. So it's a game of chicken. And the new chair has to decide whether to swerve or hold the line. Luna: One thing is for sure—the next few FOMC meetings are going to be anything but boring. Lucas: Yeah, this is a pivotal moment. Warsh has the chance to define his tenure in the first hundred days. If he navigates the vigilantes well, he builds credibility. If he stumbles, the bond market will be unforgiving. Luna: Well, we'll be watching. Thanks for listening.