On Wednesday last week, the Federal Open Market Committee unanimously voted to raise its benchmark interest rate by 0.25 percentage points, bringing the federal-funds target range to 3.75% to 4%, marking the Fed’s first rate hike since July 2023.

This was the biggest policy decision Kevin Warsh has made since becoming Federal Reserve Chair a few months ago.

As monumental as this rate hike was, it yielded a surprisingly calm reaction in the bond market.

Stocks initially took the decision in stride before slipping as Warsh spoke. The S&P 500 moved modestly lower while the two-year Treasury yield, which closely tracks expectations for Fed policy, jumped.

Farther out on the yield curve, the reaction was much calmer. Despite hiking rates, the 30-year Treasury yield initially fell slightly after the announcement. And even after the 10-year yield moved back toward 5% during Warsh’s press conference, longer-term yields remained in a relatively narrow range.

That reaction looks strange after an interest-rate hike yet it carries an encouraging message.

The Fed has enormous influence over short-term borrowing costs.

When policymakers move the federal-funds rate, yields on short-term Treasury securities typically react quickly. That’s exactly what happened on Wednesday. The two-year yield rose sharply as investors increased their expectations for higher policy rates ahead.

The 30-year yield works differently.

A 30-year Treasury has to compensate investors for decades of inflation, economic growth, government borrowing, and uncertainty. Its yield reflects the market’s collective view of where those forces are headed over a much longer period.

That made this summer’s rise in long-term yields especially important.

At the Fed’s July meeting, Warsh declined to give investors much guidance about what would prompt the central bank to raise rates. The Fed held rates steady in a 9-to-3 vote, and the bond market wasn’t happy.

The 30-year Treasury yield surged to roughly 5.23%, which was its highest level in 19 years. Measures of long-term inflation expectations moved higher as well.

By this month, the pressure had intensified. The 30-year yield was around 5.4% heading into Wednesday’s meeting, up from roughly 5.2% earlier in September.

Investors were sending a clear signal. They wanted evidence that the Fed would keep inflation under control.

That concern carried an added political dimension. President Donald Trump nominated Warsh in March and has publicly pushed for lower interest rates. Warsh took office in May, inheriting a Fed facing persistent inflation and unusually intense pressure over the direction of rates.

Then, last week, the committee voted 12 to 0 to raise rates.

Its statement said inflation remains elevated and that the move would support a faster return toward the Fed’s 2% goal. Warsh reinforced that message during his press conference, saying inflation had remained too high for too long.

Higher short-term rates can restrain demand and inflation. If investors believe the Fed is willing to tighten policy enough to preserve stability, they need less compensation for the risk that inflation stays elevated for decades.

The Fed raised the price of money today and simultaneously reduced one source of uncertainty hanging over long-term bonds.

A calmer bond market can steady everything else. That said, a rate hike still creates some near-term pressure for the economy.

Businesses face higher short-term financing costs, and consumers will feel the tighter credit conditions. Stock investors likewise have to account for a higher hurdle rate when valuing future earnings.

Yet the long end of the Treasury curve matters across the economy. Mortgage rates and corporate borrowing costs both take their cues from longer-term government yields.

A spiraling 30-year yield would create a much broader problem than one quarter-point Fed hike. Last week’s decision showed that the Fed is willing to act when inflation remains elevated, even as Warsh continues to avoid laying out every future move in advance.

Greater confidence at the long end of the curve can make the entire financial system a lot steadier.

Best regards,

Joel Litman & Rob Spivey
Chief Investment Officer &
Director of Research
at Valens Research

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