Kevin Warsh's bond market bind

"The yield on 30-year U.S. Treasury bonds has surged to 5.11%, its highest level since 2007. The rate was 4.63% at the end of February. It sets up an environment where the Fed may well need to prevent inflation expectations - as reflected in bond traders' bets - from coming unmoored. It's a paradox of monetary policy: Sometimes, the only solution for higher long-term interest rates is higher short-term interest rates."

"Warsh has argued that AI will ultimately be disinflationary - that productivity gains will lower the cost of producing goods and services and give the Fed room to cut rates. But now the AI capex boom is running so hot that it's offsetting the traditional growth-dampening effect of the oil shock, keeping demand resilient. Warsh's thesis may yet prove out. But the evidence for the disinflationary case hasn't shown up in the data yet, while the near-term inflationary scenario is plain to see in both the data and in every trip to the gas station or grocery store."

"Zoom in: U.S. demand has proven robust, and the Iran war has driven up energy prices, creating an inflationary surge. Government borrowing remains high, around 6% of U.S. GDP. As such, global investors are demanding higher compensation to park their money in Treasuries. But if the Fed were to cut its short-term interest rate target in the face of that shift, it could unmoor inflation expectations further, resulting in even higher long-term rates. Conversely, a pivot toward a rate hike or two this year could assure investors that the Fed, despite Warsh's recent dovish rhetoric, won't let inflation get out of control."

The yield on 30-year U.S. Treasury bonds rose to 5.11%, the highest level since 2007, up from 4.63% at the end of February. Higher long-term yields create pressure for the Fed to prevent inflation expectations from becoming unmoored. Monetary policy can require raising short-term rates to achieve higher long-term rates. AI-related productivity benefits are expected to be disinflationary, but current AI capex spending is running hot and is offsetting other growth-dampening forces, keeping demand resilient. Robust U.S. demand, the Iran war, and elevated energy prices are driving an inflationary surge. Government borrowing remains high near 6% of GDP, supporting investor demand for higher Treasury yields. Cutting short-term rates could worsen inflation expectations and push long-term rates higher, while rate hikes could reassure markets that inflation will not be allowed to run.

Read at Axios