Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Bond Vigilantes Are Testing the New Fed Chair
Transcript
- Lucas: So the ten-year Treasury yield just closed at four-point-five-seven percent. That is up twenty-five basis points in five days, and it is the highest print since late 2023. Luna: And that is happening while the Fed funds rate is sitting at three-point-six-four, effectively unchanged since the last meeting. The spread is getting uncomfortably wide. Lucas: Exactly. And the term — bond vigilantes — is suddenly everywhere again. Ed Yardeni, who actually coined the term back in the 1980s, came out this week and said the Fed will have to hike in July to appease them. That is a pretty specific call. Luna: He is not wrong about the signal the bond market is sending. When the long end reprices that fast, it is usually the market doing the Fed's job for it. Lucas: Right. And look at the context. CPI came in hot for April — the headline number hit three-three-two-point-four, up from three-three-zero in March. Core CPI also ticked up. So the inflation data is not cooperating with the narrative that the Fed is done. Luna: And the ten-year breakeven inflation rate actually dipped a bit this week to two-point-four-four percent. So the sell-off is not purely about inflation expectations running away. Lucas: That is the crucial nuance. The breakeven going down while nominal yields go up means the move is about term premium — investors demanding more compensation for the risk of holding long-dated bonds. That risk is partly fiscal, partly about uncertainty over the new Fed chair. Luna: Kevin Warsh gets sworn in tomorrow. Friday. So the market is basically saying, 'We don't know what this guy is going to do, and we want to be paid for that uncertainty.' Lucas: And Warsh inherits a very specific situation. The Fed funds rate is at three-point-six-four. The market is pricing in a decent probability of a hike by July, according to fed funds futures. But Warsh has not given any detailed policy signals since his nomination. Luna: What would a hike in July actually accomplish? If the move is about term premium, not about inflation accelerating further, would raising the short rate even address that? Lucas: It might not directly. But the bond vigilante logic is: if the Fed does not act, the market will keep selling off long-dated debt, pushing yields higher and tightening financial conditions anyway. The Fed would be following, not leading. Luna: And there is precedent for that. 1994, 2013 — the taper tantrum — the bond market forced the Fed's hand when it felt the central bank was behind the curve. Lucas: Exactly. Though the current situation is different. Back then, the economy was accelerating more clearly. Right now, GDP growth is moderate. The Russell 2000 is down one-point-six percent over the past five days. Small caps are feeling the pinch from higher rates. Luna: Yeah, the NASDAQ is off one-point-four percent in the same period. The rate-sensitive sectors are getting hammered. Lucas: So the vigilantes are not just a metaphor anymore. They are an active force in the market. And the question is whether Warsh will try to preempt them or wait to see if the sell-off stabilizes after he takes office. 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, that is the link. Even a small contribution keeps these conversations going without any sponsor noise. So buy me a coffee dot com slash fexingo. Luna: Alright. Back to the bond vigilantes — one thing that is interesting is that the sell-off has been concentrated in the long end. The two-year yield actually dipped a bit this week, from three-point-six to three-point-five-six. Lucas: That tells you traders are not expecting the Fed to hike aggressively. If they were, the two-year would be spiking as well. The curve is steepening, which is exactly what happens when the market starts to doubt the central bank's credibility on inflation. Luna: So the curve steepening itself becomes a message. The Fed might look at that and think, 'We need to reassure the market that we are serious.' Lucas: And the easiest way to do that is rhetoric. Warsh could use his swearing-in speech on Friday to signal a hawkish tilt. He does not have to move rates immediately. He just has to convince the bond market that he will if he has to. Luna: But Yardeni is saying he will have to actually move by July. That is a specific timeline. Lucas: Yardeni has been making that case for a few weeks now. And he was early to call the inflation persistence story. So people are paying attention. But the data between now and the July meeting — two CPI prints, two employment reports — could change the calculus. Luna: If the job market softens, the narrative flips. But if inflation stays sticky, the bond market will keep selling off. Lucas: And that is the bind. The Fed does not want to be seen as reacting to market tantrums. But ignoring a twenty-five basis point move in the ten-year in a week is also dangerous. The vigilantes have a history of escalating until they get what they want. Luna: So what does Warsh actually do on day one? He has the FOMC meeting in mid-June. That is three weeks away. Does he use that meeting to send a signal? Lucas: He could. The June meeting is a live one, with a new Summary of Economic Projections and a press conference. That is the perfect venue to reset expectations. If the dot plot shifts higher, that alone could calm the bond market without a rate move. Luna: But the risk is that the market wants action, not words. And if the sell-off continues through June, the pressure to hike in July becomes intense. Lucas: It is a delicate dance. And the bond vigilantes know it. They are testing the new sheriff before he even pins on the badge. Luna: One thing that is different from the 1990s is that there is a lot more debt outstanding now. The fiscal deficit is larger. So higher rates have a bigger impact on the government's borrowing costs, which feeds back into the fiscal picture. Lucas: Absolutely. The Treasury is issuing a lot of debt to finance the deficit. If yields stay elevated, that increases the cost of that debt, which worsens the deficit, which leads to more issuance. It becomes a loop that is hard to break without fiscal consolidation. Luna: And the Fed cannot solve that. That is a Treasury and Congress problem. Lucas: Right. So the bond vigilantes are essentially saying: we are going to charge you more for the risk of holding U.S. debt until we see a credible plan to address the fiscal trajectory. The Fed can only do so much. Luna: So where does that leave Warsh? He is walking into a situation where the market is already skeptical, inflation is sticky, and the fiscal backdrop is deteriorating. Lucas: He is a seasoned central banker. He served as a Fed governor during the financial crisis. He knows how to communicate with markets. But this is a different kind of test. It is not a liquidity crisis. It is a credibility crisis — the market questioning whether the Fed has the will to maintain price stability. Luna: And the irony is that the Fed just finished a tightening cycle. The funds rate went from near zero to over five percent, then they cut to three-point-six-four. And now they might have to hike again. Lucas: That would be unusual. A hiking cycle, then cuts, then a hike again within a year. It would look like they lost control of the narrative. Luna: Which is exactly what the bond market is pricing in. The ten-year yield does not lie. Lucas: So the bottom line is this: the ten-year at four-point-five-seven percent is a message from the bond market to the incoming Fed chair. The message is 'prove you are serious.' How Warsh responds in the next few weeks will set the tone for his entire tenure. Luna: And if he does not respond, the vigilantes will keep pushing until they get a response. Lucas: That is the uncomfortable truth. The bond market has a vote, and right now it is voting for higher rates.