We get the Fed decision this week.

The ECB raised rates last week, into an energy supply shock-driven inflation number, and European yields have since risen (benchmark German 10-year yields). The euro has fallen. And risk premiums in Europe widened on the move.

Why? Because increasing borrowing costs will do nothing to lower the cost of energy in Europe.

Still, the ECB is sending signals to markets that more rate hikes are coming. 

As for the Fed, the market is now pricing in a hike this week, and as many as two more by March.

As we've discussed, the new Fed, under Warsh, is not about giving the market signals. As Warsh has said, he wants the markets to "play the ball, not the referee."  

That said, the market knows the old Fed playbook. And Warsh sits at the table with old Fed loyalists. So the market reads three dissenters at the last meeting (who favored a July hike) as signal.

And with that, the U.S. 10-year Treasury yield has been marching higher and traded above 5% today, for the first time since 2023.

Let's talk about that 2023 episode. 

It was October of 2023 when the 10-year yield tested 5%. The Fed, under Powell, was holding real rates high, and they surprised markets by sending a more hawkish signal in their September meeting — even as inflation was falling.

In response, the 10-year yield started a 64 basis point climb toward the 5% level.

Stocks traded down 5% as rates headed toward 5%.

Mortgage rates traded to 23-year highs.

Investment grade corporate bonds were at one-year lows. 

And at the time, oil had made a 40% surge in the third quarter, up to $95, driven by war in the Middle East. And with that rate and energy market dynamic, in October the Bank of Japan was forced to intervene in the currency markets to defend the value of the yen. 

Sound familiar? 

It turns out the 5% level in the benchmark bond yield was financial stability kryptonite — enough to flip the switch at the Fed.

Just weeks after setting the bond market repricing into motion, Jerome Powell delivered a prepared speech to the New York Economic Club and said that financial conditions had "tightened significantly" since their September meeting (i.e. long-term bond yields).

Translation: If the Fed needed to do more, the bond market had done it for them (and maybe too much). It signaled the end of the tightening cycle.

The reprieve in the bond market was immediate. And within two months 10-year yields were trading under 4%.  

And keep in mind, inflation (both headline and core) was in the mid 3% area (similar levels to now). And Powell backed off the tightening policy path as inflation expectations were, at that time, much higher than current levels. 

So, three years ago the bond market did the tightening and the Fed took the excuse.

This week the market expects a hike. But the bond market has again done the tightening, and has given Warsh an excuse to hold. 

Moreover, Warsh doesn't think you raise rates into a supply shock. He has said that pushing down demand (through higher policy rates) until it meets supply is "not my mental model."

Add to all of this, Warsh said in his Senate confirmation hearing that he prefers the Dallas Fed's "trimmed averages" to measure inflation. That number was 2.3% in July. That would put real rates around 150 basis points, which is about the level of October 2023 (policy rates – trimmed mean PCE).