Executive summary

1. The bond market didn’t appear too happy in the wake of the Fed’s July press conference.
    
2. It’s not the immediate market reaction that matters, but rather the Fed’s interpretation of long-term trends impacting the economy.
    
3. That’s not as clear as you might think.
    
4. The yield curve gives mixed signals; it’s moved higher, but not because of higher inflation expectations.
    
5. Rather, real yields get the credit, and parsing the drivers there isn’t straightforward.
    

At the July Fed meeting, Kevin Warsh and company delivered the outcome most anticipated by futures pricing: They held rates steady. But the bond market disapproved. Take a look at the change in the U.S. Treasury yield curve before and after the Fed meeting in our “Chart of the month” below.
 

The bond market’s early consternation may not reflect the decision itself. It could, instead, reflect questions that arose from a hold with three dissents — all in favor of a rate hike — and a statement that emphasized inflation over labor concerns.

But let’s not discount Warsh’s press conference itself. We’re all (including, it seems, Warsh himself) adjusting to the Fed’s new effort to abstain from forward guidance. Not only did Warsh avoid saying much about future decisions, he also avoided saying much about the decision the Fed had just made to keep the Fed funds rate steady, leaving most observers confused about the Fed’s interpretation of prevailing economic conditions.

Of course, the failure or success of Fed policy is not determined by the market’s immediate reaction. What ultimately matters is whether the Fed correctly interprets the forces shaping the economy. Consider the Fed’s three rate cuts in the fall of 2025. In hindsight, the market’s initial reaction told us far less than where we stand today, with a (generally) stable labor market and persistent inflation, driven not only by the war but also, as former Fed Chair Jerome Powell observed as early as the March 2026 Fed meeting, by lingering tariff inflation in goods; an AI inflationary effect; and little progress in non-housing services pricing (also known as supercore inflation).

The cuts then — and the concerns now — reinforce the idea that it is far harder than it looks to correctly interpret and react to the long-term trends in the economy.

In the prevailing environment, take the yield curve. At face value, it makes perfect sense that it would move higher over the course of 2026 in response to sticky inflation and the on/off war in Iran, which elevated gas prices and runs the risk of secondary effects if the supply shock continues.

However, it hasn’t actually been inflation expectations that have shifted the yield curve higher this year. In fact, over the course of the year, breakevens — or the difference between real (inflation-adjusted) and nominal rates — remain contained, even over shorter maturities, suggesting that investor perception of future inflation remains anchored.

Instead, the nominal yield curve has moved higher on the back of real rates. Real rates are driven by several factors, including expectations for economic growth; the future path of policy rates (and the uncertainty surrounding it); and technical factors, such as the supply of and demand for U.S. Treasuries.

Let’s take each of those potential drivers in turn. Economic growth has certainly outpaced the expectations many had of an inevitable recession. But it’s hard to reconcile the recent 1.5% real gross domestic product (GDP) print for the second quarter with real rates moving markedly higher due to an accelerating economic environment. GDP forecasts remain similarly muted, making it less likely that the market anticipates a sudden acceleration from here.

However, even without higher GDP estimates or discernible signs of AI-fueled productivity gains, we see some early signs of an AI effect, most notably with hyperscaler debt issuance.  

In fact, it’s this issuance that some consider a potential driver of the higher yield curve. While the hyperscaler bonds live in the credit market, their expanding presence could drive the Treasury yield curve higher as they soak up demand that may otherwise gravitate toward the Treasury market.

There may be more yet to the story. Consider the term premium, which the Federal Reserve Bank of New York estimates has moved higher over the past several years, with another jump thus far in 2026.

The term premium is the additional compensation investors demand for holding longer-term bonds instead of rolling over a series of shorter-term securities. One way to think about it is as an uncertainty premium; it captures investors’ collective ambiguity around the future path of rates; the near-, intermediate-, and long-term effects of AI; the evolving state of inflation; and other future unknowns, like questions around the massive U.S. debt burden.

If uncertainty is indeed becoming a bigger driver of long-term rates, it also changes how we should think about monetary policy. Monetary policy is always a game played in the dark, but it seems especially uncertain today, with the dynamics we face across AI, inflation, and fiscal sustainability. So what’s the Fed playbook for this kind of uncertainty? In his 2018 Jackson Hole address, Powell compared monetary policy decisions to a doctor prescribing medicine: “…when unsure of the potency of a medicine, start with a somewhat smaller dose.” I continue to prefer former ECB president Mario Draghi’s 2019 analogy, though: “In a dark room, you move with tiny steps.”

This brings us back to last month’s rate decision: a hold in July is not inconsistent with these frameworks. As noted, market-based measures suggest inflation expectations remain anchored. Meanwhile, the source of inflation isn’t entirely clear; at least part of today’s inflation reflects supply shocks, which may not be overly sensitive to a higher Fed funds rate.

However, without much explanation around its decision, it’s not clear this is the Fed committee’s collective assessment. And don’t forget about the three dissents; three more dissents than the decision in June. The internal conflict and limited explanation, combined with an uncertain inflationary backdrop, makes meetings live — in other words, not settled outcomes — in a way they wouldn’t otherwise be. As of August 12, futures prices indicate a 64% chance that the Fed will hold interest rates steady and a 36% chance that the Fed will raise rates in September. The upshot of that split view? Unless the market gets greater clarity soon, Fed decisions — and the associated press conferences — have the power to move markets.

In fact, I’d suggest that any time Warsh steps up to the microphone, markets could move. Take the Fed’s annual meeting in Jackson Hole, which this year is August 27-29. Warsh plans to hold the standard press conference at the conclusion of the meeting. Any clues he offers on what replaces the Fed's forward guidance, any discussion of evolving frameworks (including his recent suggestion to cut the number of Fed meetings from eight to six), or any description he provides of the prevailing economy could influence Fed futures pricing and the broader yield curve.

What I’m watching

So. Clearly the Fed and the yield curve — along with the underlying dynamics of inflation and the labor market — weigh heavily on my mind in this environment. I do wonder at what point the yield curve proves more problematic for equity markets, the rotation trade in particular. I’m also keeping an eye on the on/off Iran war, the back half of earnings season, and the swinging sentiment around AI.

Until September.  

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