The bond market is sending conflicting signals to the Federal Reserve, forcing policymakers into a difficult balancing act that could determine the economy’s trajectory.
Treasury yields continued climbing Thursday as investors priced in persistently elevated inflation, rising energy costs, and the financial pressures of a global artificial intelligence investment arms race.
The Fed has historically looked past temporary inflation spikes caused by energy prices and tariffs, treating them as short-lived shocks unlikely to cause lasting price pressures.
Officials had also assumed the AI investing boom would run its course within a year or two and ultimately prove disinflationary, but that view is now being challenged internally.
Fed officials are increasingly concerned that inflation may be more durable than previously thought, prompting a significant rethink of the policy path ahead.
“The time of looking through the initial supply shock has come to an end,” said Joseph Brusuelas, chief economist at RSM. “The bias has to be towards restoring price stability, and they should take what’s going on seriously.”
Traders have moved aggressively to price in rate hikes, raising the odds of an October increase just weeks after the Fed’s most recent quarter-point move.
Markets also see a third hike arriving either late this year or early in 2027, with additional increases possible in the months that follow.
That represents a dramatic pivot from the Fed’s June projections, which suggested one hike this year before a gradual shift toward cuts in subsequent years.
RSM’s modeling found that even a 10-year yield of 5.5%, above Thursday’s reading of roughly 5.15%, would slow growth to 1.5% and push unemployment to 4.7% while keeping core inflation stuck at 2.4%.
“The Fed is underestimating what’s going to be necessary to restore price stability — that we’re probably not talking two or three hikes. We’re talking five or six,” Brusuelas said.
Not all Wall Street voices share that urgency, with some strategists arguing markets are overreacting to oil price swings and geopolitical tension in the Middle East.
“The rise in yields has not been due to expectations of a too-dovish Fed allowing inflation to persistently exceed target. Instead, the rise has been in real yields as investors priced-in the Fed setting higher policy rates,” said Citigroup economist Andrew Hollenhorst.
New York Fed President John Williams said Thursday that another hike by year-end is “reasonable,” but cautioned against locking into a pre-set forward guidance track before studying incoming data.
Philadelphia Fed President Anna Paulson also signaled that further tightening is likely but described potential moves as “modest,” stopping well short of endorsing a rapid succession of hikes.
Krishna Guha, head of economics and central bank strategy at Evercore ISI, warned that the Fed’s lack of forward guidance creates serious risks in either direction depending on its next decision.
“Delivering back-to-back hikes — particularly without forward guidance as to how to interpret them — would risk sending a very hawkish signal that would reprice the rates curve further and to an unpredictable extent,” Guha said.
Chairman Kevin Warsh has broken from post-2008 central bank tradition by deprioritizing forward guidance and instead allowing market signals to shape policy decisions more directly.
“No Chairman of the Board of Governors of the Federal Reserve has emphasized considering the signals from financial markets as an input into monetary policy decisions as strongly as Chairman Warsh,” wrote UBS economist Jonathan Pingle.
UBS’s Pingle also speculated that Warsh’s views align more closely with Cleveland Fed President Beth Hammack, one of the most hawkish voices on this year’s voting committee, than with any other FOMC member.
“Mr. Market is signaling something to policymakers like Kevin Warsh that they ought to listen to,” Brusuelas said, pointing to overheating risks in the investment sector as a key concern driving yield pressure.
