A "Welcome Gift" for the New Fed Chair: Walsh Takes Office, and the Market Already "Raises Rates"

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Waller has not yet chaired his first Federal Reserve monetary policy meeting, but the bond market has already given him a "rate hike gift" in advance.

On Thursday, May 14, according to Wallstreetcn, U.S. retail sales in April posted the strongest monthly gain in eight months, confirming consumer resilience. However, inflationary pressures continue to rise, dashing hopes for an imminent rate cut.

After the data, the yield on the interest rate–sensitive 2-year U.S. Treasury rose 4 basis points, climbing above 4%. The 10-year Treasury yield rose to 4.48%, about 50 basis points higher than at the end of February.

This latest round of bond market repricing is stripping away the policy flexibility that the new Fed Chair, Waller, could have had. Vincent Ahn, fixed income portfolio manager at Wisdom, explicitly stated: Waller originally hoped to have a rate cut option on his first day in office, but the bond market has already taken this option off the table.

Bond market front-runs, overall yield curve rises

Yields in the roughly $30 trillion U.S. Treasury market have risen across the board.

This week, the 30-year U.S. Treasury yield broke through the 5% level. Although it temporarily pulled back below 5% overnight, the yield closed at 5.030%.

In addition, the 2-year yield climbing above the upper bound of the Fed's short-term interest rate target range of 3.7% is particularly noteworthy.

Normally, the 2-year Treasury yield does not continue to exceed the federal funds rate target range, and this abnormal pattern implies that before Waller’s first policy meeting (scheduled for June 16-17), the market has already carried out a rate hike on its own.

Vincent Ahn characterized this as a typical operation of the “modern bond vigilantes”:

They do not destroy the Fed’s credibility with a single spike in yields, but rather erode its policy options bit by bit by pushing the entire curve above the policy range.

Inflationary pressures persist, oil prices are a key variable

Behind the tightening bond market are inflation signals from the real economy.

Since the outbreak of war in Iran, oil prices have risen sharply, and the average national gasoline price in the United States has exceeded $4.50 per gallon.

Touchstone Senior Fixed Income Strategist Erik Aarts recently paid over $6.50 per gallon at a gas station in California. He stated, not only is this “very painful,” but it also constantly reminds him that once high oil prices continue to erode household disposable income, it will substantially drag down consumer spending.

Many Americans have no choice but to pay higher gas prices for commuting, which means the proportion of wages spent on other consumption is shrinking. Aarts said:

The threshold for Fed rate hikes is getting lower.

According to the CME FedWatch tool, as of Thursday, the market-implied probability for a Fed rate hike before early December has exceeded 30%, the probability of holding rates steady is about 60%, and the probability of a rate cut is only 1.3%.

Despite rising inflation expectations, the reality of the labor market is constraining Fed decision-making.

The unemployment rate in April remained at a relatively low 4.3%, but the overall labor market has almost stagnated. Wellington fixed income manager Brij Khurana emphasized that the Fed places great importance on the labor market.

He pointed out that the drivers of current inflation are completely different from the wage-driven inflation of 2022. The emerging employment concerns from AI replacing white-collar jobs are also fermenting in the market. He said:

We are almost monitoring the situation minute by minute.

In his view, as the Iran war continues, the blow to economic growth from the conflict will be even more profound than the shock of inflation.

Historical precedent: New chairs face market tests upon taking office

Deutsche Bank’s Jim Reid noted that it has long been understood that new Fed chairs typically face rapid market turmoil after taking office, although actual data shows a more complex picture:

Arthur Burns took office in February 1970 when the U.S. economy was already in recession;Paul Volcker's aggressive rate hikes after his appointment led to economic contraction;Alan Greenspan’s tenure began in the aftermath of Black Monday in 1987;Jerome Powell faced the pandemic suddenly after two years in office.

When Waller takes over, the stock market is at a historic high, and markets have quickly recovered from the initial shock of the Iran war. However, the "welcome gift" from the bond market may be a truer test for the new chair.

Chair Powell, who succeeded under President Trump, took a cautious stance on rate cuts, while Waller previously defended low-rate policies in a high-inflation context.

Now, the bond market has made it clear with its actions that it does not intend to cooperate with this position.

Risk Reminder and DisclaimerThe market involves risks, and investments must be made cautiously. This article does not constitute individual investment advice and does not take into account the special investment objectives, financial situation, or needs of specific users. Users should consider whether any opinions, views, or conclusions in this article fit their own circumstances. Any investment based on this is at their own risk. ```