Federal Reserve Chairman Waller spoke on Friday, and the market is focused on what

Original Title: Kevin Warsh's Jackson Hole Speech Puts Bond Yields on Notice
Original Author: Michael J. Kramer
Compiled by: Peggy

Editor’s Note: On August 28 (this Friday), according to the schedule released by the Federal Reserve, Chairman Kevin Warsh will deliver his first Jackson Hole speech since taking office. Investors are not only focused on whether he will hint at the next direction of interest rates but also whether he will continue to reduce forward guidance, allowing the market to form its own interest rate expectations.

Note: The Jackson Hole Global Central Bank Annual Conference is hosted annually by the Kansas City Fed and is an important meeting for central bank officials to discuss economic and monetary policy. It is also a key window for the market to observe signals from the Federal Reserve's policies.

Michael J. Kramer presents a more controversial interpretation in this article: Warsh may not intend to actively suppress long-term rates like previous Federal Reserve chairs but rather hopes to allow the yield curve to steepen, tightening financial conditions through higher term premiums and bond volatility. Under this framework, the Federal Reserve may suppress demand through the pressures on mortgage rates, corporate financing costs, and stock valuations, even without raising policy rates.

This remains the author's speculation about Warsh's policy intentions and is not a confirmed policy arrangement by the Federal Reserve. What is truly noteworthy is that if the Federal Reserve reduces its management of market expectations, long-term rates may no longer merely reflect the path of rate hikes passively but could become an independent variable affecting financial conditions. Friday's speech will provide the first important validation of this judgment.

The following is the original text compilation:

In the first half of this week, market attention was mainly focused on Nvidia's earnings report; after Wednesday, the focus will shift to the Jackson Hole Global Central Bank Annual Conference.

Federal Reserve Chairman Kevin Warsh is scheduled to deliver a keynote speech on August 28. This will be his first appearance at Jackson Hole since taking office and an important window for the market to observe his monetary policy framework. The schedule released by the Federal Reserve and the Kansas City Fed indicates that the speech will begin at 10 AM Eastern Time.

Investors will focus on whether Warsh has changed his stance on reducing forward guidance. Forward guidance is a policy tool used by central banks to influence market expectations of future interest rate paths through public communication. In the view of the article's author, Michael J. Kramer, it is highly likely that Warsh will not change direction: the Federal Reserve will reduce its "hand-holding guidance" to the market, allowing economic data and market prices to play a more significant pricing role.

The resulting impact may not be limited to policy communication. Kramer assesses that Warsh may allow long-term yields and bond volatility to rise, thereby tightening financial conditions and reducing the necessity for immediate rate hikes.

Term Premium Returns, Will 10-Year U.S. Treasuries Return to 5%?

The author observes that the term premium on U.S. Treasuries has begun to rise. The term premium is the additional return that investors require for holding long-term bonds instead of continuously rolling over short-term bonds, primarily used to compensate for future interest rate, inflation, and policy uncertainties.

This article uses the ACM term premium model published by the New York Fed. ACM refers to the estimation framework established by Tobias Adrian, Richard Crump, and Emanuel Moench, which is used to decompose long-term Treasury yields into expected short-term rates and term premiums. It should be noted that the term premium cannot be directly observed, and different models may yield different results.

According to the data cited by the author, the 10-year U.S. Treasury ACM term premium is about 82 basis points, still below the average level of about 150 basis points from decades before QE was implemented. If the term premium rises to this historical average, combined with the author's assumption of a neutral rate slightly above 4%, the 10-year Treasury yield could rise above 5%.

The ACM term premium on the 10-year U.S. Treasury has rebounded, but according to the author, it is still below the long-term average level before QE.

This calculation is more of a scenario projection rather than a definitive prediction of the 10-year yield. It relies on two key assumptions: that the term premium continues to rise and that the long-term neutral rate remains at a high level. Any change in either condition could lead to significantly different results.

However, what the author is truly concerned about is not the specific point of 5% but the pricing logic of long-term rates: if the Federal Reserve no longer actively reduces policy uncertainty, investors may demand higher term compensation.

No Rate Hike, but Bond Volatility Can Still Increase

Reducing forward guidance may also push up the implied volatility in the bond market.

Despite the recent rise in long-term yields, the MOVE index, which measures the implied volatility of U.S. Treasury options, remains at a relatively low level. The author interprets this as the market still believing it can roughly predict the Federal Reserve's next policy path.

Long-term yields have risen, but the implied volatility of U.S. Treasury options has not yet been significantly re-evaluated. The author believes that reducing forward guidance may change this state.

If this certainty disappears, each monetary policy meeting could become an "open event": investors would not be able to rule out the possibility of rate hikes, cuts, or continued pauses in advance, and bond prices would become more sensitive to economic data and policy statements. Without actual adjustments to rates, U.S. Treasury volatility could undergo a structural re-evaluation.

The author believes that this change itself could tighten financial conditions. Higher 10-year yields would transmit to mortgage and corporate long-term financing costs, lowering the valuations of long-duration assets like stocks; higher interest rate volatility could also widen credit spreads, increasing corporate borrowing costs.

It is important to downgrade the understanding that the federal funds rate remains the core tool of the Federal Reserve's monetary policy and should not be simply considered "unimportant" for short-term rates. The author presents another layer of market interpretation: beyond the policy rate, long-term yields and bond volatility can also affect the real economy, and their transmission may be more direct.

Allowing the Long End to Tighten, Then Creating Space for Short End Rate Cuts

In the policy framework envisioned by Kramer, the Federal Reserve may allow the yield curve to continue steepening, letting long-term rates take on the tightening function that has not been fully utilized in the past.

Specifically, the Federal Reserve could reduce forward guidance and no longer strive to eliminate the uncertainty of each policy meeting. In an environment where supply, inflation, and fiscal risks still exist, investors would demand higher term premiums, pushing long-term yields and bond volatility higher, allowing the market to complete part of the tightening.

If this process can suppress demand and drive inflation to continue falling, the Federal Reserve may subsequently lower short-term policy rates. At that time, the yield curve may show long-term rates remaining relatively high while short-term rates gradually decline.

In other words, the path envisioned by the author is not the traditional "raise rates first, then cut rates" approach, but rather allowing the long end to tighten financial conditions first, then creating space for short-term rate cuts.

However, this framework carries obvious risks. The rise in long-term yields is not entirely under the control of the Federal Reserve. If the increase in term premiums is too large, mortgage, corporate financing, and fiscal interest burdens may come under pressure simultaneously; if the market interprets the reduction in communication as a lack of clarity in the policy framework, the rise in volatility may damage the Federal Reserve's credibility rather than help it achieve orderly tightening.

Therefore, it cannot yet be confirmed whether the rise in long-term rates is a policy channel that Warsh hopes to utilize or an additional compensation demanded by the market for inflation, fiscal, and policy uncertainties.

Japan's Rate Normalization Adds Pressure to Global Long-Term Bonds

In addition to changes in U.S. policy, the author also views Japan as another driving factor for rising global interest rates.

According to the latest policy from the Bank of Japan, the target for the uncollateralized overnight call rate is currently about 1%. Meanwhile, the 10-year breakeven inflation rate in Japan is approaching 2%. The breakeven inflation rate is the difference between the yields of nominal government bonds and inflation-linked bonds of the same maturity, usually seen as the market's estimate of future inflation, but it also includes liquidity and risk premiums.

Japan's 10-year breakeven inflation rate has risen to about 2%, and market expectations for the Bank of Japan to further normalize monetary policy have intensified.

The author believes that the rebound in Japan's inflation expectations indicates that the market is preparing for the Bank of Japan to further normalize its monetary policy. According to the TONAR futures pricing cited by the author, the market-implied rates are approximately 1.19% for September, 1.41% for December, and 1.6% for March of the following year. These figures reflect the market pricing at the time of the article's publication and will continue to change with economic data and policy expectations, not representing a confirmed rate hike path by the Bank of Japan.

The TONAR futures pricing at the time of publication shows that the market is factoring in the possibility of continued rises in Japan's short-term rates. Futures prices will change with data and policy expectations, not representing a confirmed rate hike path by the Bank of Japan.

If Japanese rates continue to rise, global demand for low-yield overseas bonds may marginally weaken, and global long-term rates will face more upward pressure. In such an environment, even if Warsh does not release a clear signal for rate hikes, long-term U.S. Treasury yields may not easily decline.

What needs to be observed on Friday is how Warsh describes the rise in long-term yields: will he view it as having already completed part of the tightening for the Federal Reserve, or does he believe that higher term premiums are bringing uncontrollable financial risks? Will he continue to reduce forward guidance, and will he explain how the Federal Reserve hopes the market understands its policy response function?

Only with clearer answers to these questions can we determine whether "allowing the long end to tighten for the Federal Reserve" is indeed a policy framework that Warsh may adopt or a story that the market has filled in based on his silence.