The Big Picture

Briefing.com Summary:

*There is a disconnect between the Fed's projections and market pricing.

*Rate cuts have been pushed out, and the risk of a rate hike is rising, driven by persistent inflation and the energy price shock.

*Rising global yields and weaker Treasury demand tighten financial conditions, threatening growth, valuations, and fiscal stability.

"Take the SEP forecasts now with a grain of salt. They are subject to a very high level of uncertainty."

That is what Fed Chair Powell said during his press conference following the March FOMC meeting. It was a nod to the uncertainty surrounding the war with Iran. It is fair to take the forecasts with a grain of salt, but if we are going to do that, then we feel compelled to add in a dash of cayenne pepper.

The median estimate for PCE inflation this year was raised to 2.7% from 2.4%, the median estimate for core PCE inflation was raised to 2.7% from 2.5%, and the median estimate for the change in real GDP was bumped up to 2.4% from 2.3%. Remarkably—or maybe we should say inexplicably—there was no change in the median estimate for one rate cut this year.

That makes no sense. The fed funds futures market and Treasury market know it, and the stock market is begrudgingly accepting it.

Shifting Expectations

In early December, the fed funds futures market was expecting two rate cuts in 2026: one in April and another in September. That expectation is no longer with us.

According to the CME FedWatch Tool, the Fed isn't expected to cut rates at all this year. The real kicker is that the expectation for another 25-basis-point cut has been pushed out to October 2027!

Things started to slip with the recognition that inflation was remaining stubbornly above the Fed's 2.0% target, but the real push came from the spike in energy prices that coincided with the attack on Iran, its subsequent weaponization of the Strait of Hormuz, and its retaliatory strikes on other Middle East countries.

It became apparent to market participants that the hoped-for rate cut is going to be later rather than sooner, assuming there isn't a rate hike first. It's worth noting that the CME FedWatch Tool shows at least a 40% probability of a 25-basis-point hike at the October 2026 FOMC meeting.

Foreign Exchange

The energy price shock isn't a unique management problem for the Fed. Every central bank needs to grapple with it, and sovereign bond markets are recognizing that. Bond yields have risen appreciably here and elsewhere, as participants are pricing out rate cuts, and in some cases, like the BOJ, Bank of England, Reserve Bank of Australia, and ECB, pricing in rate hikes.

The 2-yr note yield, for instance, has spiked 52 basis points this month to 3.91%, with rate cut expectations getting swept away. The 10-yr note yield is up 42 basis points to 4.38%, with inflation concerns escalating. This is known as a bear flattener trade in the Treasury market, where short-term rates rise faster than long-term rates, and it isn't the stock market's friend.

These higher yields will be an impediment, certainly for the housing market and equity valuations, and they will simply worsen an already bad fiscal situation for the U.S., as the interest expense that comes with financing and refinancing our massive debt is rising.

The added problem is that, as yields rise elsewhere, U.S. Treasuries become relatively less attractive to foreign buyers, who can take advantage of higher yields again in their domestic markets while avoiding currency risk.

The 10-yr U.K. Gilt yield hit 5.00% for the first time since 2008, while Australia's 10-yr note yield topped 5.00% for the first time since mid-2011. Therefore, it might take even higher yields here to entice foreign buyers to step up their purchases of U.S. Treasuries.

The Iran war, then, which unleashed oil prices, may just end up haphazardly unleashing bond vigilantes if current trends persist. That is a battle the U.S. government doesn't want to be fighting.

Briefing.com Analyst Insight

Ultimately, the issue isn’t just uncertainty—it's inconsistency. The Fed’s updated projections acknowledge firmer inflation and resilient growth, yet its rate outlook hasn’t adjusted accordingly, creating a disconnect that markets are rapidly correcting on their own.

With energy prices injecting fresh inflation pressure and global yields moving higher, financial conditions are tightening whether the Fed intends them to or not. That leaves policymakers in a reactive position, while investors are forced to recalibrate for a higher-for-longer reality.

In that sense, investors are taking the SEP with a grain of salt, but they are rightfully concerned about the cayenne pepper that is rising inflation and rising bond yields.

--Patrick J. O'Hare, Briefing.com