In just 10 days, the world changed—Kevin Warsh’s debut as chair of the Federal Reserve compounded with an oil unwind. The two tenets that have been driving financial markets for the past few months flipped.
On the back of the conflict in Iran, oil climbed as high as $126 per barrel in late March. Prices have fallen since over 40% in about 60 days, with the steepest leg of that trade coming in the last few weeks. For everyday Americans, that has driven the average national price of gasoline to drop from a peak of over $4.50 per gallon to below $4.00—a boon for those worried about energy prices potentially curbing consumer spending.
Perhaps the real sea change came from Kevin Warsh’s first Federal Open Market Committee (FOMC) meeting mid-June. Long perceived as someone with an easing bias, his debut as Fed chair marked a hawkish departure from expectations toward the end of his predecessor’s tenure. Investors had already largely priced out interest rate cuts ahead of his debut, in reaction to commodity-driven inflation and firmer economic data.
In theory, inflation running above the Fed’s 2% target provides little reason to cut interest rates. But during the late innings of Chair Powell’s tenure, perceived weakness in the labor market allowed just that. And a series of “insurance cuts” helped power risk assets.
As a result, investors also flocked to real assets that represented stores of value that wouldn’t be eroded by inflation. Take gold as an example. Its rise from $3,500 per troy ounce in September last year to a peak of just under $5,500 in January was symptomatic of this policy stance by the Fed.
Chair Warsh’s debut in the June FOMC meeting broke that mold.
The policy statement of his first meeting as chair was drastically shortened, with forward guidance eliminated and language interpreted as an easing bias removed. The Summary of Economic Projections (SEP) showed an upward revision to inflation and a hawkish tilt in the dot plot. The vote was framed as “unambiguous and unanimous” on delivering price stability, and marked a stark contrast with the Powell-era of a communication-heavy, guidance-dependent approach.
Chair Warsh went so far as to mention the forecasts were “coming in with pencils…with big erasers,” acknowledging that the drivers of the global economy and the United States are changing quickly. But the idea of a Fed less willing to tolerate above-trend inflation is already having a material impact. Market-implied inflation expectations have fallen sharply with both two-year and 10-year inflation swaps now below pre-conflict levels.
In other words, a renewed willingness to hike interest rates (or even the absence of an easing bias) gives the bond market far greater conviction in lower long-term inflation—especially when faced with the prospect of higher oil prices.
But what if the higher energy prices aren’t a problem anymore?
The last two inflation reports were primarily driven by the energy shock making up almost half of the headline number, with nearly a $20 drop in oil prices in June yet to be reflected in the latest inflation reports. National gasoline prices have already followed the decline in the benchmark, but the more notable move is in the bond market. Since the conflict in Iran, the 40-day correlation between bond yields and oil prices has risen, with the two assets moving in lockstep. The logic is simple: Higher oil prices are inflationary, and therefore part of the decision making process for the monetary policy, which is then reflected in the bond market.
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