Fed needs to raise rates in July to appease ‘bond vigilantes’, Yardeni says

Market veteran Ed Yardeni said incoming Fed Chairman Kevin Warsh, who was sent to the Fed to lower interest rates, may instead need to push for higher rates to establish credibility.

Yardeni, who coined the term “bond vigilante” to describe such events of investor anxiety, added that if the new central bank leadership does not demonstrate that policymakers are in tune with inflationary pressures, it risks further market anger in the form of rising bond yields.

“Warsh is set to become chairman of the Federal Open Market Committee (FOMC) in June, but who is actually in control of monetary policy? We would argue it is the bond vigilantes,” Yardeni, head of Yardeni Research, wrote on Monday. As for sentiment among policymakers, he said: “Warsh is going to be a strange guy. But he’s the new Fed chairman, and the bond market is reacting badly to his dovish stance.”

U.S. Treasury yields soared on Friday, with the 30-year note above 5%, the highest level in nearly a year. Long-term bonds were little changed at 5.138% on Monday morning. Two-year bonds, which are more sensitive to changes in Fed interest rates, fell slightly to 4.07%.

In a statement before becoming chairman, Warsh said he believed it was possible for the Fed to lower the benchmark interest rate to 3.75% from its current target range of 3.5%.

However, while the recent spike in inflation was primarily caused by the Iran war, there are other underlying factors as well, leading to a re-up in market interest rate expectations.

But Warsh’s appointment has made the situation even more complicated. Not only does the market not believe the Fed won’t cut rates, but the likelihood of a rate hike is increasing, with current pricing suggesting a 42% chance of a rate hike by the end of the year, according to CME Group’s FedWatch tool.

But Yardeni thinks it will happen sooner than that. He expects the Fed to keep rates unchanged at its June meeting, but thinks a 0.5 percentage point hike is “likely” in July. But he believes Warsh’s Fed could take the first step toward tightening in June by removing so-called forward guidance language from its postmeeting statement, which has been interpreted to mean the Fed’s next action is to cut interest rates.

“To avoid losing control of borrowing costs and appease the bond vigilantes, the Fed needs to catch up with the bond markets,” he said. “They may need to consider a tightening stance rather than a neutral stance by now. An unexpected FFR rate hike may actually please them!”

Yardeni argues that the Warsh Fed’s early tightening bias will help ease bond market concerns, keep yields in check and allow the Fed flexibility later on.

“So by acting hawkishly, Mr. Warsh may have a chance to achieve what the White House wants: lower real-world borrowing costs,” he said. “Mortgage rates could fall, corporate lending could ease, and President Trump could point to lower long-term yields as a win for the economy.”

Mr. Yardeni’s call for a rate hike in July is a sharp departure from consensus. Although market odds increase throughout the year, the implied probability of a rate hike in July is currently just 4.2%, according to FedWatch.