Shifting tides in how the market is reading the Fed

The market is still learning how to interpret Chair Kevin Warsh's Fed. That adjustment may create periods of volatility, but it should not distract investors from the broader opportunity in bonds.

The bond market is still adjusting to Chair Warsh's communication style and seeking clarity around the Federal Reserve's reaction function. While price stability was reinforced in his first press conference, his recent press conference left markets with higher long-term yields and uncertain confidence in the Fed addressing the above-trend inflation dilemma.

Such shifting tides are not novel for leadership changes at the Fed. Historically, Fed chair transitions introduce uncertainty, not through wholesale policy updates, but through changes in communication, interpretation, and implementation. Even subtle shifts in tone or reaction function can alter how markets price risk and drive greater volatility.

Investors shouldn't get lost in the noise. Chair Walsh is likely to adjust his communication to reestablish credibility, creating an opportunity in fixed income for investors who can stay disciplined through near-term uncertainty.

Inflation expectations remain anchored—albeit at above target. Also, the yield curve is offering attractive compensation in intermediate maturities as well as appealing real yields, a key signal of the attractiveness of the bond market today.

Inflation remains anchored

A dominant market narrative continues to focus on the risk that inflation may prove more persistent than expected, leading to higher interest rates. The concern is understandable, given the conflict in the Middle East driving oil prices and, consequently, recent increases in headline inflation.

The Fed reaffirmed a hawkish bias at this meeting. Three dissenting members of the Federal Open Market Committee are now in favor of a hike, and Warsh is continuing to reject any soft inflation target while downplaying June’s weak inflation data as only a single month of data.

With this commitment from the Fed, combined with our outlook for lower inflation prints for the balance of this year, we believe investors should take comfort in the path toward lower inflation. Longer-term inflation expectations also reflect this sentiment, remaining anchored near long-term averages.

Investors may be underestimating opportunities in duration

Despite inflation risks and some market jitters as investors adjust to the Fed's evolving communication style, our outlook for bonds remains constructive.

Real yields continue to offer one of the most compelling entry points for long-term fixed income investors in years. Current valuations suggest markets expect stronger long-run growth and a structurally higher neutral policy rate, referred to as r*.

For example, the forward Secured Overnight Financing Rate curve remains above 4% out to 10 years.

The yield curve is offering better compensation for investors

Compared with a year ago before the Fed cut rates in September 2025, the U.S. Treasury yield curve has regained a more normal upward slope.

That shift has restored term premium to intermediate and longer maturities. The additional steepening following the Fed's July 28–29 meeting has made the entry point even more attractive for investors willing to own duration.

The belly of the curve looks more attractive

When the yield curve was inverted, investors had less incentive to own the belly. But today, intermediate maturities look more compelling because investors may be able to collect roll-down return by holding those bonds over time.

The belly also carries less exposure to interest rate volatility than the long end, as shown by the 30-year yield reaching nearly 20-year highs after the Fed meeting while the 10-year yield was unchanged.

Intermediate-duration bonds can still provide reasonable return potential even if rates do not rally meaningfully. Also, yield carry can generate income while helping provide ballast to a portfolio.

Real yields remain a key indicator of the current opportunity

Real yields measure what investors are paid above inflation to own duration. Yields above 2% represent meaningful compensation and mark a clear contrast with the post-global-financial-crisis period, when real yields were near zero or negative for much of the cycle.

Simply put, bonds present a compelling outlook today because investors can compound attractive real yields while retaining the potential for price appreciation if inflation moderates and yields move lower.

The risk

Our research indicates that in the near term, inflation is likely to moderate. Also, AI productivity gains may further support price stability in the future.

On the other hand, inflation does remain elevated currently, with the ongoing conflict in Iran a clear near-term risk. Also, the potential for disappointing AI-related productivity gains remains a long-term risk.

While we see room for the Fed to continue being patient, the risk of a recalibration hiking cycle has risen. But even considering this risk, bond investors are well-compensated today.

In our view, a hiking cycle from the Fed today would likely result in taking back last-year's policy adjustments—in other words rate hikes of 75–100 basis points (bps). The market continues to price in close to 50 bps of hikes, meaning much of this risk is already priced into markets.       

The bottom line

Recent volatility reflects the market adjusting to Chair Warsh's communication style rather than a fundamental change in outlook.

While the latest Fed press conference clouded confidence and pushed yields higher, we believe inflation is still likely to moderate. With real yields near multi-year highs, a steeper curve, and much of the hiking risk already priced in, intermediate duration bonds remain more attractive than many investors appreciate.

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