Warsh's Hawkish Speech Flattens Yield Curve, Sends Markets into a Tug-of-War

Federal Reserve Chair Kevin Warsh made his most hawkish speech since taking the job at Jackson Hole, which surprised markets and flattened the yield curve overnight. The August 30th speech was a departure from Warsh's previous rhetoric, where he expressed concerns about underlying price pressure and financial conditions.

The market reaction to Warsh's speech was swift, with the 2-year yield rising and the 10-year falling, causing the gap between them to compress to under 40 basis points. This is a technical indicator that suggests investors now believe the Fed is willing to hold rates higher for longer and credible enough to keep long-term inflation expectations in check.

The yield curve flattening has significant implications for mortgage pricing, as it tracks the 10-year Treasury yield more closely than the Fed's overnight rate target. A hawkish speech that convinces markets of credibility can lead to lower long-term borrowing costs, even if short rates remain high. This is exactly what happened in this case.

The backdrop for Warsh's speech was a mixed bag, with corporate profits surging 9.1% in the second quarter and after-tax margins at a record high. However, the Fed's own New York branch has tracked a smoother measure of underlying inflation falling for three straight months to 2.67%, giving doves ammunition.

The practical interpretation for households and small business owners is that mortgage and business-loan rates are being set by a tug-of-war between Warsh's hawkish talk and inflation data that's genuinely ambiguous. If the inflation numbers turn back up, the hawkish talk will turn from credibility-building into a genuine tightening cycle, and borrowing costs could rise.