Market Pulse

Research evidence excerpt

Market Pulse

It was only last week that the 2-year yield (now at 4.08%) moved more than 25bps higher than the upper end of the Fed Funds

target range (3.75%), even though the US-Iran War (and the oil price spike) began more than two months prior, and even though

long-term (10-year) inflation breakevens have been inconsistent with the Fed's 2% inflation target since the first few days after

the War began. Even as of this morning, there remains a begrudging belief that the Fed will raise its policy rate, and that

reluctance to do so has probably exacerbated the sell-off in the long-term bonds in the US and the steepening yield curve. USD

OIS markets are assigning merely a 55% (hardly a sure thing) probability to a Fed hike by end-2026, even though recent inflation

is nearing 4%. The last time that US CPI inflation was that high was in mid-2023. But at that time, the Fed Funds rate target was

above 5.0%, even though inflation was already on the downswing.

Figure 1 - US: Two-Year UST Yield and Upper Bound of the Fed Funds Rate Target

Source: Bloomberg LP

What has kept the Fed "dovish" so far? It probably has been (1) a reluctance to view the US-iran War as a permanent feature

of the outlook (i.e., supply shocks will dissipate), and (2) a willingness to downplay second-round effects on inflation through self-

fulfilling higher inflation expectations; and (3) a reluctance to believe that the inflation risk premum - the premium paid by bond

issuers to compensate for inflation that is unpredictable - can have a material effect on long-term real investment prospects.

Finally, (4), the prospect that the Fed is getting a new Chair in Kevin Warsh, who is also unwilling to acknowledge the gravity of

overall supply-side constraints, may be playing a part in the Fed's lateness.