As Kevin Warsh is set to chair the Fed, bond investors are betting he will prioritise the central bank’s inflation-fighting mandate over Trump’s push for lower interest rates, just like his processor.

Traders are pricing in that it is certain to see rate hikes by December. That marks a sharp reversal from just three months ago, when they were betting there were deeper cuts ahead.

US economic resilience, high energy costs and an AI-investment boom have fuelled concerns that inflation could remain stuck above the 2% target for some time and push rates into a red zone.

The 2-year Treasury yields climbed to its highest level in more than a decade on Friday. After Trump took office, reflation is back with protectionist trade policies and wars targeting rival states.

A supertanker hauling Iraqi crude to China left the Persian Gulf and crossed the US blockade line into the Arabian Sea on Monday, igniting hope that the Strait of Hormuz will be reopened in the near future.

But Iran and the US played down hopes for an imminent breakthrough on Monday. Iran’s foreign ministry spokesperson said nuclear issues – Trump’s top concern – had not been discussed.

Investors bought a net $21.89 billion of ⁠global bond funds in the week through May 20 as they extended the recent buying streak into a seventh successive week, according to LSEG Lipper data.

Bond vulnerability

PCE price index is seen to rapidly approach 4% as a spike in energy costs generates unease that price pressures will broaden. Even the core reading likely picked up in April to the fastest pace since late 2023.

Consumer sentiment tumbled to a fresh record low in May, the University of Michigan’s Surveys of Consumers said. Not only so, inflation expectations over the year ahead rose to 4.8% from 4.7% last month.

Manufacturing activity scaled the highest level in four years this month, offsetting the service sector cooldown. Meanwhile, overall measure of prices paid by businesses jumped, indicating more price pressures ahead.

S&P Global Market Intelligence chief business economist Chris Williamson said "that the economy will struggle to manage annualized GDP growth of much more than 1% in Q2."

As of 22 May, iShares 3-7 Year Treasury Bond ETF had dropped approximately 2.1% from its record peak hit in late February. A fiscal black hole also helps deter potential buyers of the fund.

The federal debt has now surpassed the size of economy, a historic threshold that has not been crossed since the conclusion of WWII. Apparently Trump’s promise to balance budget fails to deliver.

Wall Street strategists said that the recent jump in some long-term yields will not fully reverse even if the inflation spurred by the war retreats. That means the downturn in the fund may still have room to run.

Besides inflation

Long-term Treasuries have been hit significantly harder than short-term peers lately, as a shift toward a “bear steepening” yield curve triggered a painful selloff at the long end of the maturity spectrum.

“The interaction between rising debt levels, potentially higher neutral rates, and AI could be driving real rates higher” given pricing of long-term bonds, said Jonathan Hill, head of US inflation strategy at Barclays.

Although AI holds the potential to curb long-term inflation through productivity gains, the short-term impact remains upsetting with tech conglomerates keep aggressively spending on R&D.

Additionally, accelerated economic growth from the AI surge will likely drive capital into equities, requiring bonds to offer more attractive yields to entice money managers.

A Bloomberg analysis shows rising real yields explains most of the move higher in overall yields in the US and Britain, whereas inflation appears the major influence in Japan and Germany.

In an interview last week, Jamie Dimon, chief executive officer of JPMorgan, said US interest rates may climb much further, citing concern about government borrowing and demand for the debt.

Gold prices will put under intense pressures in the circumstances. SPDR Gold Shares ETF has risen for three years consecutively, but we doubt whether it can hold on to its gains this year.

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