The Bond Market Is Taking the Fed’s Hawkish Cue

Executive Summary

Kevin Warsh’s arrival as Fed chair is reinforcing a more hawkish tone and a deliberate shift toward letting markets take the lead in pricing interest rates. Bond investors appear to be accepting that invitation. Real Treasury yields have climbed to multi-year highs, the yield curve has flattened sharply, overnight index swaps have repriced toward a higher policy path, and mortgage spreads remain historically wide.

Warsh’s ‘Market-Led’ Policy and Real Yields

Warsh, in his first press conference, highlighted that inflation has persistently run above the Fed’s 2% goal for over five years, describing high prices as a burden on Americans. He expressed comfort with markets taking a more active role: “The more that markets are paying attention to what’s happening in the real economy… the more financial markets can price what they believe is the most likely and what the tail risks are.”

Markets have responded. The 5‑year TIPS yield now trades around 2.0% to 2.03%, its first sustained move through that threshold in over a year and roughly 90 basis points higher than levels seen in late February. The 10‑year real yield is also above 2%, and the long end of the curve is higher still, with 30‑year TIPS yields around 2.6% to 2.7%. Recent auctions tell the same story: a mid‑June reopening of 5‑year TIPS cleared at 1.955%, well above the 1.367% real yield from the original April issue of the same security.

Warsh has said “financial markets perform best when they react to incoming data,” and hotter headline inflation since the war with Iran, particularly via energy prices, has lifted real yields as investors reprice both the baseline and tail risks for future policy.

Swaps, OAS and MBS: How Markets are Repricing Policy

The hawkish shift is visible beyond TIPS. In the derivatives markets, US 5‑year swap rates have moved up to the low‑4% area, around 4.17–4.19% in late June, reflecting higher expectations for the Fed’s medium‑term policy rate. The 5‑year Treasury note yield is near 4.20%, putting the 5‑year swap spread close to flat to slightly negative; a sign that bank and dealer balance sheet constraints remain tight and that investors are demanding more term premium in Treasuries.

Mortgage-backed securities (MBS) spreads have widened relative to Treasuries, with agency MBS option-adjusted spreads (OAS) remaining elevated near multi-year highs despite some recent tightening. This behavior stems from heightened rate volatility, reduced convexity hedging needs, and investor demands for risk premia in a less dovish environment. Current coupon agency MBS OAS has hovered in ranges indicating caution, with spreads to Treasuries around levels not seen consistently in years.

Interest-only (IO) strips, which benefit from slower prepayments in higher-rate environments but suffer from extension risk, have exhibited mixed performance. IO spreads have widened as markets price in potential policy firming, increasing uncertainty around mortgage refinancing and duration. Prepayment risk premia in stripped MBS have contributed to this divergence, with IOs offering opportunities but carrying elevated volatility.

What to Trade

The bond market’s leadership role appears to be functioning as Warsh intended, with real yields acting as a barometer for tighter policy needs. However, uncertainties remain. While headline inflation is elevated due to energy shocks, core measures are more moderate. Progress in Iran talks could ease energy prices, potentially capping further yield rises.

In this environment, one could consider the following positioning. Add TIPS in the 5–10 year sector, funded from nominal Treasuries. Locking in real yields at or slightly above 2% offers attractive inflation‑adjusted income relative to recent history, especially if energy‑driven headline inflation proves sticky for longer than core measures suggest.

Investors may also favor a modest flattening bias in the swaps curve. With 5‑year USD swap rates around 4.17% and the 2s10s spread only slightly positive, receiving longer‑dated swaps versus paying shorter maturities can benefit if the Fed delivers fewer hikes than now priced but keeps policy restrictive, anchoring the front end while term premium and growth uncertainty cap the long end.

A tilt toward higher‑quality spread assets is also conducive in this environment, especially agency MBS, over tight corporate credit. Current‑coupon agency MBS spreads are still wider than pre‑war norms, offering compelling compensation for interest‑rate and convexity risk with explicit or implicit government backing, compared with compressed spreads in investment‑grade corporates. In a more hawkish regime, a barbell exposure also works well, with high‑quality MBS and TIPS on one side, and only selective, short‑duration corporate or structured credit on the other.

We would remain cautious on lower‑quality, long‑duration credit. A Fed that is willing to let markets do more of the tightening raises the odds of bouts of spread widening in high‑yield and deeply subordinated debt if inflation surprises again. We would avoid reaching for yield at the long end of the credit curve until swap and breakeven markets signal clearer disinflation.

For now, Warsh appears content allowing markets to tighten financial conditions on the Fed’s behalf. Judging by the behavior of Treasury yields, swaps, mortgage spreads and credit markets, investors have already begun doing exactly that.

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