As investors focus on the likely confirmation of new Federal Reserve Chairman Kevin Warsh, many may be overlooking the bond market, which could have a more volatile reaction. After each Fed transition, movements in Treasury yields, duration risk, and credit spreads typically accelerate as markets begin to reassess monetary policy.
“What’s really important in the coming weeks is the change at the Fed chair level,” Paisley Nardini, managing director and head of multi-asset solutions at Simplify Asset Management, said Monday on CNBC’s “ETF Edge” podcast segment.
Nardini explained that even in the absence of immediate policy action, markets could quickly start pricing in the future. A new Fed chair could change his communication style and change the pace of future rate hikes or cuts. He said this could send ripples through the bond market before the stock market fully reacts.
“Markets are going to be really cautious about what this means. Every time there’s a change in vigilance, markets are going to experience some volatility. We’re going to have to start pricing in what that means.”
There was a lot of Fed news to digest this week. The Federal Reserve kept interest rates on hold at Wednesday’s meeting, leaving the federal funds rate unchanged at a range of 3.50% to 3.75%. But the war and soaring oil prices have upended the policy assumptions of central banks and bond traders, who are now betting on another rate cut in 2026. Fed Chairman Jerome Powell added that pressure on the economy from rising oil prices is likely to continue, even if the long-term inflation outlook has not yet turned upside down.
But there is more disagreement within the Fed than ever before, and a shift is occurring within the FOMC, with more members saying there should be no sign at all from the Fed that it remains biased toward cutting rates. Powell also said he has no intention of leaving his position on the Fed’s board when his term ends, further complicating the already heightened political environment at the Fed.
This backdrop could make bond markets more sensitive, with the latest personal consumption expenditure index hovering around 3.5% annually, and inflation remaining above target. Core PCE rose to 3.2%.
“If you remember the role of the Fed, we have a dual mandate, and it’s data-driven, so on one side you have jobs and on the other side you have inflation,” Nardini said, referring to the economy’s goals of maximum employment and 2% inflation. “Often people forget about bonds until they become the focus of a portfolio, and it’s too late to react or adjust the portfolio accordingly,” he said.
There is reason to believe that more investors may have chosen to ignore bonds during Mr. Powell’s tenure at the Fed. Their methods were terrible. The Bloomberg U.S. Aggregate Bond Index, which tracks all U.S. investment-grade bonds, returned just under 2% a year during Mr. Powell’s tenure, well below the 6.5% average since the 1970s, Bespoke said. The culprit was an era of high interest rates driven by inflation accompanied by multiple shocks, from the coronavirus to Russia’s invasion of Ukraine to the current war between the United States and Iran.
Nardini points out that with the Fed currently in hold mode, the first big risk for bond investors is duration. If investors are loading up on long-term bonds and hoping for rate cuts, they could be vulnerable if they arrive late or not at all. The 10-year Treasury note has soared already this year and currently yields more than 4%.
The second risk is creditworthiness. Nardini said corporate spreads remain relatively tight, meaning investors are not being rewarded as much for taking on additional risk on bonds above the risk-free Treasury rate. This dynamic could become even more important later in the cycle as economic and credit weakness increases. “We need to really analyze how much of the yield within the credit is coming from government bonds compared to the spread component,” he said.
Credit spreads are at historically tight levels, recently testing multi-decade lows, reflecting a belief among investors that default risk is low and the economic outlook is strong. But at the same time, markets were increasingly betting that the yield curve would steepen this year, as even if the Fed held policy unchanged, long-term rates faced the prospect of persistent inflation and high levels of public debt, while short-term rates remained more sensitive to an eventual Fed cut.
Credit market conditions have caught the attention of Jamie Dimon, CEO of JPMorgan, the nation’s largest bank, who this week did not point out any specific signs of the current credit market, but warned: “We’ve never had a credit recession this long, so if there is a credit recession, it’s going to be worse than people think. It could be bad.”
Nardini says it’s important to remember that during periods of relative calm, calm can be deceptive. “When markets become complacent, whether it’s stocks or bonds, that’s usually when volatility occurs,” he said.
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