The market bets on a Warsh hike

The two-year Treasury yield rose to about 4.24 per cent on 21 August, as markets stopped pricing rate cuts from the Fed and started pricing a rise under its chairman, Kevin Warsh. Rate futures and the yield curve both shifted sharply towards the hawkish side.

Wall Street gives up on cuts

The move marks Wall Street's full retreat from the idea of easier money. Two-year yields are trading well above the Fed's policy range of 3.50–3.75 per cent, and interest-rate swaps now put a very high probability on the Federal Open Market Committee raising the federal funds rate by 25 basis points at its September meeting.

The two-year note is the cleanest single reading of those bets. Its yield is roughly the average policy rate investors expect over the next two years plus a small premium for tying money up, so a yield well above the current range means the market expects the funds rate to spend much of that period higher than it is today. Earlier in the summer the same note traded as though the next move would be a cut, and the reversal came in steps: the collapse of talks in the Gulf, a firmer inflation print and three hawkish dissents at the July meeting.

Reading odds from the curve

Turning prices into probabilities is simple arithmetic. Fed funds futures settle on the average effective rate over a calendar month, so a contract for October reflects the rate expected once the September decision has been made. If that contract implies a rate about 25 basis points above today's effective rate, the market is treating a rise as close to certain, and if it implies half that, the odds are roughly even. SOFR futures and overnight index swaps give the same reading further out, and together they trace the path traders expect meeting by meeting.

The method has limits worth stating. Futures prices carry a risk premium as well as a forecast, and in a sell-off that premium can push implied rates above what traders actually expect. Heavy positioning by leveraged funds can exaggerate a move for a few days before it unwinds. A shift of this size in futures, swaps and the two-year note at the same time is still hard to dismiss as noise.

Warsh must show his hand

Traders reckon Warsh cannot keep policy loose while headline inflation climbs to 3.4 per cent and oil sits near $100. To build credibility and defend the Fed's commitment to fighting inflation, he is expected to lead the committee into tightening straight away.

A new chair has particular reason to act early. Markets test a central banker who has not yet raised rates, and a chair who looks reluctant invites higher inflation expectations that cost more to reverse later. Warsh served as a Fed governor from 2006 to 2011 and has long criticised the size of the central bank's balance sheet, which gave him a hawkish reputation before he took the chair. Holding in September would contradict that reputation at the first real test.

Who gains from a hawkish curve

A shift at the front of the curve moves money quickly. Savers in money market funds and Treasury bills keep earning more than they expected a month ago, and the dollar tends to firm against currencies whose central banks are not tightening. Holders of two-year notes bought when cuts were still priced take mark-to-market losses, and floating-rate borrowers, from companies with leveraged loans to households carrying credit-card balances, lose the relief they had pencilled in.

Lenders feel the shift on both sides of the balance sheet. A higher two-year yield raises rates on adjustable mortgages, car loans and many small-business loans priced off short-term benchmarks, and it lifts the rates banks must offer to stop deposits moving into money market funds. Lenders whose loans reprice quickly come out ahead, while those funded by rate-sensitive deposits and holding fixed-rate assets see their margins squeezed.

The width of the gap between market pricing and the current policy setting is a signal in its own right. Since the 1990s the Fed has generally preferred to confirm a move that markets have fully priced rather than surprise them by standing still, because disappointing a firm expectation can move markets more violently than the decision itself. With the two-year note well above the policy range, a hold in September would be the surprise, and the committee would have to explain why the data no longer justify what it appeared to endorse in July.

What could reverse the bet

The case against a September rise rests on the data due before the meeting. An oil shock squeezes real incomes, and if the next jobs report or retail sales show demand cracking, the committee could decide that dearer energy is doing some of its tightening for it. Markets have priced near-certain moves before and been wrong: at the start of 2024 futures priced a string of cuts that the Fed then postponed until September of that year, as inflation proved stickier than expected. Pricing can swing back as fast as it arrived.

The markers are the August jobs report, the August consumer-price figures and whatever Warsh says in public before the committee's quiet period begins in the days ahead of the meeting. Markets now expect a rise of 25 basis points in September, and with inflation at 3.4 per cent, Warsh would probably damage his credibility more by holding than by moving.