Warsh wants the bond market to do its job and look at inflation and the economy — and not at the Fed — and it’s finally doing it.

By Wolf Richter for WOLF STREET.

The 30-year Treasury yield jumped by 7 basis points on Friday, and by 12 basis points during the week, to 5.28%, the highest since July 2006, now 165 basis points above the Effective Federal Funds Rate (EFFR, blue in the chart below), which the Fed targets with its policy rates.

During the FOMC press conference on Wednesday, Fed Chair Warsh repeatedly said that ending “forward guidance” by the Fed was already working, that Treasury yields had already surged since the FOMC meeting in June when he’d scuttled forward guidance, as markets had begun to look at the inflation and economic data, and not at the Fed. Buyers and sellers were doing the hard work, and raised rates and tightened financial conditions, and this “has provided us some comfort that we’ve got the ability and capability to deliver.” In other words, the bond market was finally doing its job.

The dotted line reflects the linear trend for the data in the chart. The double line traces the higher lows since late 2023.

Buyers of long-dated Treasury securities are primarily concerned about two things:

• Inflation, which eats up the purchasing power of their principal, and they want to be compensated via a higher yield for that loss of purchasing power.
• The onslaught of supply that will require new buyers to get pulled into the market, and it may take higher yields to pull these fence-sitters to the Treasury auctions. But rising yields mean lower market prices for bondholders that had previously bought that debt at a lower yield. And new buyers want to be compensated via a higher yield for taking that risk that yields will rise further.

And those risks have been growing, and the Fed has done nothing but cut rates since the fall of 2024, though inflation has been accelerating for over a year, which has spooked the bond market.

The two-decade view shows the last 14 years of the 40-year bond bull market during which the 30-year Treasury yield fell from over 15% in September 1981 to about 1% in mid-2020, when it flipped to the bond bear market that is now wrapping up its sixth year.

The current bond bear market has been a bloodbath, triggering the collapse of several regional banks in 2023 that had loaded up on long-term Treasuries and government-guaranteed MBS in 2020 and 2021. They had believed the Fed’s forward guidance that interest-rate repression would continue for a long time. But the forward guidance was a lie. The Fed ended QE, hiked rates, and started QT in 2022, and long-term yields soared and the market prices of the long-term bonds that the banks had purchased a couple of years earlier collapsed.

The market value of 30-year Treasury bonds that the government sold at auction in mid-2020 has plunged by about 50%.

Of course, investors that bought at the auction can hold those bonds for another 24 years to maturity to get all their money back, but along the way, they’ll collect only 1.3% or so of interest per year for another 24 years, while current buyers would earn 5.28% a year, and when they get their money back in 24 years, inflation will have eaten up a big chunk of its purchasing power. Those bonds purchased in 2020 were horrible deals for the original buyers.

Before Warsh became Fed chair, he blasted the Fed for its forward guidance: Forward guidance had locked in the Fed as inflation was surging in 2021 while the Fed was still at 0% and still doing massive QE – and I called it “the most reckless Fed ever.”

And then when it finally broke loose from its forward guidance and began tightening, it was too late, inflation was out of the bottle, and wasn’t going back in, and some of the banks that had believed its forward guidance in 2020 and 2021 then collapsed in 2023.

Warsh scuttled forward guidance as one of his first moves at the FOMC and told the bond market to figure things out on its own. And the buyers and sellers in the bond market are now doing their jobs, reacting to economic data, to inflation and supply data, and not to the Fed.

The 10-year Treasury yield rose 7 basis points on Friday to 4.75%. It had briefly hit 5% during the debt-scare in October 2023, and that 5% had opened the floodgates of demand, and this massive demand pushed the yield back down.

But there is no guarantee that the floodgates of demand will re-open at 5% the next time around.

The 10-year yield at this level is not high from a historical perspective. The Fed started its interest-rate repression, including QE, in 2008. That’s what pushed down the 10-year yield to these very low levels.

Now inflation is out of the bottle, and it doesn’t want to go back in on its own, and the Fed cannot do QE in this environment.

In addition, Warsh wants to reduce the Fed’s balance sheet further as one of the ways to bring down inflation, which is the opposite of QE and could put upward pressure on long-term yields. He needs a majority at the FOMC to do that, and at the Wednesday meeting, he didn’t have a majority for anything other than maintaining status quo.

This chart shows the 40-year bond bull market from September 1981 to mid-2020, followed by the six years so far of the bond bear market:

Short-term Treasury yields of 1 year and less declined since the FOMC meeting. They’d already priced in a rate hike either at the July meeting or at the September meeting. The July rate hike didn’t come, and they’re still counting on a September rate hike, but with less conviction.

The three-month Treasury yield fell by 13 basis points during the week, to 3.83%, per Treasury Department calculations, so about 20 basis points above the EFFR (blue line). The September FOMC meeting is in its three-month window.

Treasury Yield Curve has steepened and is starting to look healthy. The chart below shows the yield curve of Treasury yields across the maturity spectrum, from 1 month to 30 years, on three key dates in 2025 and 2026:

• Red line: Friday, July 31, 2026.
• Gold dotted line: July 28, 2026, day before the FOMC meeting.
• Blue dotted line: September 16, 2025, before last three rate cuts.

The yield curve inverted in mid-2022 as the Fed had begun hiking its policy rates, which pushed up short-term Treasury yields, but long-term yields were slower in coming up and were lower than short-term yields. The inversion had triggered endless recession calls because prior yield-curve inversions had been followed by recessions.

And then, when long-term yields caught up, the yield curve developed a big sag in the middle, with yields between 1 year and 7 years lower than both short-term yields and long-term yields.

And then when the yield curve un-inverted temporarily in early 2025, it triggered more recession calls on the theory that it’s the un-inversion of the yield curve that actually predicts a recession.

And then in the second half of 2025, it developed another big sag in the middle on a new bout of rate-cut mania that was pushing down yields one to three years out (blue line in the chart above).

So now all this is behind. The yield curve finally looks healthy, but not steep – and it could be a lot steeper. Here are measures of the steepness of the yield curve:

The spread between the 2-year and 10-year yield is only 45 basis points. During periods of economic growth, that spread spent lots of time in the range of 100 to 250 basis points, indicating that the 10-year Treasury yield at today’s level is well below where it might end up going.

When the spread was negative, the yield curve was “inverted.”

The spread between the 3-month and 10-year yield is only 92 basis points. This is low for periods of economic growth, also indicating that the 10-year Treasury yield at today’s level is well below where it might end up going.

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