Warsh's Hawkish Debut Sparks Rate Hike Odds and Oil Price Surge

The recent speech by Federal Reserve Chairman Kevin Warsh has shifted the burden of proof for the economy, making it more likely that the Fed will tighten monetary policy. This shift is significant because it changes the way markets approach inflation and interest rates.

Warsh's speech at Jackson Hole changed the narrative from 'what does the economy need to do to force the Fed into tightening' to 'what does the economy need to do to keep the Fed from tightening'. This subtle change in language has a big impact on market expectations, with the yield curve steepening and rates becoming more attractive.

The bond market is now pricing in a higher probability of another rate hike, particularly for the 2-year Treasury note. However, investors are not yet convinced that this means a wholesale repricing of the cost of capital. If the 10-year Treasury note stays relatively calm while the 2-year yield remains firm, it could be seen as a constructive sign.

But there is another scenario where the bond market and equity markets collide: if oil prices continue to rise due to geopolitical tensions in the Middle East. Brent crude has risen to around $89.50/bbl, which is high enough to start leaning on inflation psychology again. This would make it more difficult for the Fed to keep inflation under control without breaking something important along the way.