Why Yields Haven't Fallen as Much as Expected
A reasonable assumption might be that hopes of a U.S.-Iran peace deal and de-escalation in the Middle East, combined with a retreat in oil prices, would pull Treasury yields sharply lower. They have not done so to the degree one might anticipate, and the dollar and the bond market have remained stickier than other asset classes. The explanation is that inflation and the price of oil and the conflict, while they have mattered a great deal recently, are not the only forces driving Treasury yields.
When you examine the overall slope of the yield curve and look at intermediate-term and long-term maturities, the same factors that have kept long-term yields elevated remain firmly in place. These pressures are likely to persist even if good news arrives in the form of a finalized deal and a continued drop in the price of oil. Several distinct forces are at work simultaneously:
- Sticky inflation. Even when energy prices are excluded, inflation remains sticky, with core inflation running around or close to 3%. Beneath the surface, there are genuine inflationary pressures.
- Budget concerns. Fiscal and budget worries are not going away anytime soon and continue to weigh on the long end of the curve.
- The global yield story. The general direction of global bond yields is helping to keep domestic long-term yields elevated.
- A strong economy. Economic strength persists, particularly fueled by heavy AI investment.
- Broad uncertainty. There is considerable uncertainty in the outlook. Even with a potential de-escalation, it is impossible to know what will happen over the next 60 days, nor how much of the impact of the earlier rise in oil prices will eventually flow through the economy over time.
Notably, several of these drivers predate the Iran conflict entirely — the budget concerns, the underlying strength of the economy, and the global yield dynamic were all present beforehand.
This overall uncertainty is itself a contributor to higher Treasury yields. The net takeaway is that the news is genuinely good, but it is not the kind of development that will suddenly allow yields across the curve to move significantly lower. Most yields will probably stay within the range they have been trading in for the time being.
The TIPS Break-Even Puzzle and Inflation Expectations
A point of apparent divergence has been raised by multiple fixed income teams across different institutions: while real yields and other measures stay elevated, TIPS break-even rates have been coming down. Why?
TIPS break-even rates are useful for gauging investor sentiment around inflation expectations, but they are an imperfect measure. It is true that inflation expectations derived from the TIPS market have come down dramatically. The five-year TIPS break-even rate, for example, is well off its recent highs and is actually sitting below where it stood at the end of February, before the conflict began.
Much of this owes to the structure of the market. The TIPS market is much smaller than the nominal Treasury market, which is why it is not the best standalone inflation indicator — it is simply one of many that deserve attention. When a broader range of inflation expectation indicators is examined, whether market-based or survey-based, they tell broadly similar stories. The precise level may differ somewhat from one measure to another, but the common signal is that expectations have come down:
- University of Michigan sentiment survey (Friday's data): Both short-term and intermediate-term inflation expectations came down from the previous month's levels.
- Inflation swaps in the market: These have not moved up sharply and remain somewhat well anchored — not totally well anchored, since there has been some volatility, but reasonably so.
Although the level signaled by TIPS may be a little skewed, it is in line with the other measures. The collective message from the markets is essentially: yes, there was a large increase in oil and gas prices, but that increase is probably behind us, and there do not appear to be embedded inflation pressures that will persist over the next several years.
A Word on the Inflation Data
Regarding last week's inflation data, the picture still appears relatively narrow. The more serious concern would arise once inflation begins to broaden out — that is the point at which it becomes a major problem rather than a contained one.
What It Means for the FOMC and Kevin Warsh's First Meeting
The upcoming FOMC meeting on Wednesday carries unusual significance because it is Kevin Warsh's first meeting at the helm, and it has generated a great deal of conjecture and anticipation — about whether the easing bias will be dropped, and whether Warsh will offer his own dot in the projections.
Policy decision: No change in policy is expected, which should surprise no one.
The easing bias: The easing bias is expected to be dropped. However, the replacement is likely to be a neutral bias rather than a hawkish one. While the economic outlook and the inflation outlook have indeed changed, they have not changed so dramatically that the next move would necessarily need to be a rate hike.
Warsh's tone: The greatest source of uncertainty is how Warsh himself will approach the role. His overall tone in this first press conference will be closely watched, because as a new chair he will want to own the meeting and put his stamp on it. His framing of the economic environment matters especially because conditions have shifted substantially since he was first nominated in January — inflation has picked up and the labor market has strengthened. If there were indicators that supported a dovish case for him a few months ago, it will be revealing to see how he frames those same conditions now and how he describes his outlook for the coming months.
The dot plot: A dot plot will probably still be produced, but two open questions hang over it. First, whether it exists at all; and second, if it does exist, whether Warsh will personally offer a dot, given that he has previously alluded to the idea of not providing his own projection. If a dot plot does appear, it is expected to be less dovish than before. The prior dot plot, from March, projected one cut later this year. It now seems unlikely that any of the officials across the committee's spectrum will be pricing in a rate cut by year-end. At the same time, the dots are not expected to suggest a rate hike either. One or two dots might project a hike, but the median is expected simply to project patience.
The overarching theme — patience and wait-and-see. Patience is the expected theme of the meeting. With a great deal of uncertainty in the environment and some genuinely good news recently in the form of falling oil prices, the Fed is in a position to adopt a wait-and-see approach. It can watch how the summer season unfolds before gathering the insights needed to determine what its next move will be.
Key Questions Asked and Answered
Why haven't yields come off as much as one would anticipate, given peace hopes and lower oil — why are the dollar and bond market stickier than other asset classes? Because inflation, oil, and the conflict are not the only drivers. Sticky core inflation near 3%, persistent budget concerns, the direction of global bond yields, a strong economy, and broad outlook uncertainty are all keeping long-term yields elevated, and several of these predate the conflict. The good news is real but will not push yields significantly lower; they should stay in their recent range.
Why are TIPS break-evens diverging downward from real yields? Because TIPS are an imperfect inflation measure, largely owing to the TIPS market's much smaller size relative to the nominal Treasury market. Even so, the decline is consistent with other indicators (Michigan survey, inflation swaps), all signaling that the oil-and-gas price spike is likely behind us with no durable embedded inflation pressures.
What should be expected for policy at the FOMC meeting? No change in policy.
Will the easing bias be dropped? Yes — expected to be replaced with a neutral bias, not a hawkish one, since the changed outlook does not make a hike the necessary next move.
Will there be a dot plot, and will Warsh offer his own dot? Probably a dot plot will appear, but it is uncertain whether Warsh will provide his own projection, having previously suggested he might not. Any dot plot is likely to be less dovish, with the median projecting patience — no cut priced in by year-end, and no hike signaled either, aside from possibly one or two dots.