U.S. Treasuries "force Walsh's hand": Just being hawkish isn't enough; the market wants a rate hike.

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The U.S. Treasury market is sending a clear signal to Federal Reserve Chair Walsh: tough rhetoric against inflation is far from enough to reassure investors.

The latest round of U.S.-Iran military conflict that broke out in July caught Wall Street off guard, pushing international oil prices momentarily above $100 per barrel and triggering a massive sell-off in the $30 trillion U.S. Treasury market. The benchmark 10-year Treasury yield has risen by more than 30 basis points since the end of June, to around 4.678%, approaching a nearly ten-year high. Meanwhile, the 2-year Treasury yield, most sensitive to monetary policy, has climbed to about 4.328%, surpassing the Fed's current upper limit of 3.75%, reflecting the market's strong expectations for interest rate hikes.

On Wednesday, the Fed will announce its latest policy decision. According to the CME FedWatch tool, as of last Friday, the market expects a 62% probability the Fed will keep rates unchanged at this meeting, but the probability of a rate hike has sharply jumped from about 13% a week ago to about 38%.

"This shows just how worried the market is about inflation and how concerned it is over whether the Fed can match its words with actions," said Gennadiy Goldberg, Head of U.S. Rates Strategy at TD Securities, referring to Walsh's series of public statements about bringing inflation back to the 2% target.

Oil shock compounds bond market pressure as Treasury yields approach ten-year highs

The U.S.-Iran conflict is the direct trigger for the recent rise in Treasury yields. Soaring oil prices have intensified worries about a resurgence of inflation, prompting traders to dump U.S. Treasuries. According to GasBuddy data, the average retail price for gasoline and diesel in the U.S. recently returned above $4 and $5.20 per gallon, respectively.

After Walsh held his first press conference as Fed Chair in June, the Treasury market briefly rebounded, but the rally quickly evaporated. The 30-year Treasury yield has stubbornly remained above 5%, inflicting heavy losses on investors who bet on long-duration bonds.

David Rosenberg, founder and president of Rosenberg Research & Associates, wrote in a report last Friday: "We did not anticipate this latest chapter of the U.S.-Iran war, which is a complicating factor for any duration asset right now." He also noted that the continued expansion of tech-related corporate bond issuance is adding pressure to the Treasury market. Rosenberg said he has adjusted his portfolio, shifting earlier underperforming long positions in 30-year Treasuries to short-duration U.S. bonds.

Paul Christopher, head of global investment strategy at Wells Fargo Investment Institute, said: "The Fed needs to heed this signal. Uncertainty is accumulating," and bond market investors are demanding corresponding compensation.

Debate over rate hike window: Policy costs and timing dilemmas

The Fed is not monolithic internally. Reportedly, some members of the rate-setting committee favor raising rates to suppress inflation. However, the issue is—any rate hike action is extremely sensitive in its timing.

Inflation itself erodes the real value of fixed income assets, while rate hikes further depress bond prices and drag on other financial assets such as equities. Meanwhile, Barclays analysts estimate the U.S. fiscal deficit will reach about $2 trillion by 2026, and sustained large-scale issuance of Treasuries will be important to fill the gap, meaning supply pressures in the bond market will not ease in the short term.

Furthermore, massive borrowing in the tech industry is amplifying bond market pressures. Major tech companies, especially "hyperscale cloud providers," are racing to issue corporate bonds to support AI infrastructure building, raising overall market borrowing costs. Moody's Ratings forecast in its report last Wednesday that these hyperscale providers' capital expenditure will approach $1 trillion by 2027, up from nearly $800 billion this year, and warned that "surging capital expenditures, rising leverage, and off-balance-sheet commitments" pose threats to this group's credit quality.

Stock market battered again, tech stocks lead decline

The cloud of high rate expectations also hangs over the stock market. Last week, semiconductor shares led the fall, with the Philadelphia Semiconductor Index dropping more than 4% for the week. The Dow Jones Industrial Average slid 0.4% for the week, the S&P 500 was down 0.6%, and the Nasdaq Composite plunged 2.1%. The Nasdaq's closing price is now 7.8% below its record high set in early June.

Higher rates usually suppress spending by businesses and consumers, dragging economic growth and eroding corporate earnings expectations. Christopher of Wells Fargo suggests investors might as well wait until the rotation in tech stocks runs its course, saying "a better entry opportunity may appear," and warns that "holding some cash reserves may not be a bad idea."

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