Kevin Warsh, a potential future Federal Reserve chair, is being compared to Paul Volcker for his hawkish stance on inflation. Like Volcker, Warsh's aggressive approach may break things in the bond market. Thirty-year Treasury yields have surged to their highest level since 2002, and the 10-year yield jumped over half a percentage point in September alone, reaching about 5.3%. This marks the worst month for U.S. government bonds in four years.
Technical market dynamics, such as a slowdown in the basis trade and an increase in the term premium, have been cited as possible explanations. However, these factors seem insufficient to account for the magnitude of the shift in the $40 trillion bond market. Strategic factors like inflation, deficits, and geopolitics remain background risks but did not drive the recent re-pricing. The Fed's sudden hawkish turn appears to be the primary catalyst.
On August 28, Warsh signaled a hawkish turn at Jackson Hole, leading to a sell-off as traders priced in a September rate hike. A hot August CPI report on September 11 accelerated the sell-off, and the Fed's actual rate hike on September 16, along with Warsh's resolute tone, further fueled market fears. Traders now anticipate more hikes, with an 80% chance of at least 100 basis points more than before Jackson Hole.
Markets remember the Fed's aggressive rate hikes in 2022-23, which caused significant losses in bonds and strained the banking sector. Traders are now cautious, preferring to overreact rather than underreact to the Fed's signals. The current rout has led to over $1 trillion in market-wide bond losses, added unrealized losses for banks, and higher mortgage rates, impacting the housing market.
Warsh seems to view the market turmoil as the cost of restoring the Fed's credibility. However, the consequences are widespread, affecting consumers, homeowners, businesses, and global economies. The key question remains whether the price of this credibility is worth paying.