The 10-year U.S. Treasury yield has risen to 4.48%, the 30-year has broken 5%, and the 2-year has reached the upper limit of the Fed's interest rate target range. The market's expectation of an interest rate hike within the year has exceeded 30%. This round of bond market repricing is compressing the policy space for the new Fed Chair Waller.

Written by: Bao Yilong

Source: Wall Street Insights

Waller has not yet chaired his first Federal Reserve monetary policy meeting, and the bond market has already bestowed a "rate hike gift."

On Thursday, May 14, according to Wall Street Insights, U.S. retail sales in April posted the strongest increase in eight months, confirming consumer resilience, but inflationary pressures continue to rise, breaking short-term hopes for rate cuts.

Following the data release, the rate-sensitive 2-year Treasury yield rose by 4 basis points to above 4%. The 10-year Treasury yield increased to 4.48%, about 50 basis points higher than the end of February level.

This round of repricing in the bond market is depriving the new Fed Chair Waller of the policy maneuvering space he could have had. Wisdom Fixed Income Portfolio Manager Vincent Ahn commented that Waller initially hoped to have a rate cut option on his first day, but the bond market has taken this option off the table.

The bond market jumps ahead, the yield curve rises overall

The yield in the approximately $30 trillion U.S. Treasury market has risen comprehensively.

The 30-year U.S. Treasury yield broke through 5% this week; although it briefly pulled back below 5% overnight, the final yield closed at 5.030%.

Additionally, the 2-year yield exceeding the Fed's short-term rate target upper limit of 3.7% is particularly noteworthy.

Typically, the 2-year Treasury yield does not remain consistently above the federal funds rate target range, and this unusual pattern indicates that the market has independently completed a rate hike cycle before Waller's first policy meeting (scheduled for June 16 to 17).

Vincent Ahn characterized this as typical behavior of a "modern bond vigilante":

They do not destroy the Fed's credibility with a sudden spike in yield but instead encroach on its policy options bit by bit by pushing the entire curve above the policy range.

Inflation pressures persist, oil prices are a core variable

Behind the tightening bond market are inflation signals in the real economy.

Since the outbreak of the war in Iran, oil prices have surged significantly, with the national average gasoline price in the U.S. exceeding $4.50 per gallon.

Touchstone Senior Fixed Income Strategist Erik Aarts recently paid over $6.50 per gallon while refueling in California. He noted that this not only "hurts very much," but also constantly reminds him that if high oil prices continue to erode disposable income, it will have a significant drag on consumer spending.

Many Americans have no choice but to continue bearing higher fuel costs for commuting, which means the proportion of their wages allotted for other consumption is shrinking. Aarts stated:

The threshold for Fed rate hikes is lowering.

Data from the CME FedWatch tool shows that, as of Thursday, market expectations of the Fed raising rates before early December have exceeded 30%, while the probability of maintaining rates is about 60%, and the probability of rate cuts is only 1.3%.

Despite rising inflation expectations, the reality of the labor market constrains the Fed's decision-making.

The unemployment rate in April remained relatively low at 4.3%, but the labor market overall is nearly stagnant. Wellington Fixed Income Manager Brij Khurana emphasized that the Fed places a high priority on the labor market.

He pointed out that the causes of current inflation are fundamentally different from the wage-driven inflation of 2022, and new employment concerns arising from AI replacing white-collar jobs are also fermenting in the market. He said:

We are almost examining the situation minute by minute.

In his view, as the war in Iran continues, the impact of the conflict on economic growth will be more profound than the inflation shock.

Historical precedent: New chair faces market tests upon taking office

Jim Reid from Deutsche Bank pointed out that historically, new Fed chairs have quickly encountered market turmoil upon taking office; this understanding has been long-standing, despite the actual data presenting a more complex picture:

• Arthur Burns faced recession when he took office in February 1970;
• Paul Volcker's aggressive rate hikes initiated after he took office triggered economic contraction;
• Alan Greenspan's era began after the "Black Monday" crash of 1987;
• Jerome Powell faced the pandemic two years into his term.

When Waller took over, the stock market was at historical highs, and the market had rapidly recovered from the initial shocks of the war in Iran. However, the "welcome gift" from the bond market may present a more realistic test for this new chair.

Waller has previously defended low-interest-rate policies against high inflation. Now, the bond market has made it clear through its actions that it does not plan to accommodate this stance.