How chaos at the Fed might impact US bond markets further

The Trump administration is trying to exert political pressure on the US Federal Reserve. They’ve exerted that pressure through aggressive rhetoric and criticism of Fed Chair Jerome Powell, they’ve named more Trump-friendly governors to replace retiring members of the FOMC, and they’ve attempted to fire Governor Lisa Cook. The pressure has increased on the US central bank incrementally, and bond markets have responded accordingly with a gradual steepening of the US yield curve. Bond investors have essentially come to the consensus that political pressure will work to result in Fed rate cuts, but the risk of those cuts coming for the wrong reasons means inflation risk is higher, resulting in an increase in longer-duration yields.

David Stonehouse accepts that the metaphor of a boiling frog might apply to bond investors in this scenario. The Interim CIO at AGF Management Limited notes that because political pressure on the central bank has been increased slowly, markets have been inculcated to this scenario and have reacted quite reasonably and moderately to a potential fundamental change in US monetary policy. He believes that the Fed is likely to start cutting rates, but that markets may not be fully aware of the risks associated with why the Fed will cut.

“I think the fear should grow that the Fed runs the risk of making policy moves for the wrong reasons,” Stonehouse says. “That's certainly going to become the key area of increasing focus as we move forward here. If inflation remains sticky, GDP and employment remain resilient, and yet you've got a more aggressively easing Fed, then clearly the markets are going to be buying into the notion of political influence.”

Should that scenario play out, Stonehouse says there could be room for the yield curve to steepen and for the US dollar to weaken. An increase in inflation as a result of potential cuts, too, could be extremely unwelcome as inflation appears sticky in the US at well above two per cent and trending in the wrong direction. Questions as to whether tariffs result in a one-time price increase or stickier inflation remain unanswered. Stonehouse notes that owner-equivalent rent in the US is trending lower, which could help keep inflation in check over the short-term. Next year, however, he expects US GDP growth to pick up as the economy digests tariffs and the stimulus in Trump’s “Big Beautiful Bill.” That increase in growth, coupled with potentially less data-driven cuts might result in higher inflation again.

Threats to Fed independence, though, have also resulted in speculation as to whether the so-called ‘bond vigilantes’ might punish the US government by raising yields on US treasuries. Stonehouse notes that we may already have seen some vigilante action in the steepening of the yield curve that’s already occurred. However, that action has not resulted in something as meaningful as the 2022 UK mini budget largely because US growth expectations remain intact and will likely outpace US inflation. Moreover, US deficit issues remain less acute relative to other developed markets.

While politicization of the Fed may seem risky to bond investors, Stonehouse notes that the environment actually presents a great deal of opportunities that advisors should be aware of. The first is the possibility that the Fed cuts more aggressively than markets anticipate, on the back of both political pressure and potentially supportive data. Stonehouse sees that as a likely opportunistic environment in the short to medium-term.

Should inflation re-accelerate, Stonehouse sees opportunity in inflation-linked bonds. If politicization of the Fed results in US dollar weakness over time there could be opportunities in other reserve currencies as well as gold.

Stonehouse also notes that most of the risk in bonds has been focused on the long-end of the yield curve. However, as the Trump administration exerts more pressure on the Fed it becomes more likely that US Treasury Secretary Scott Bessent coordinates more directly with the incoming Fed Chair. Together, those figures may be able to exert greater control over the long end of the yield curve. That could see an end to quantitative tightening or even the resumption of quantitative easing policies aimed at bringing the long end back down.

Despite opportunities out there on the market, some clients may be expressing broad concerns about US bonds as political pressure and headline risk aren’t normally associated with this more defensive asset class. Stonehouse notes, though, that despite all these issues US bonds have been largely rangebound for the past three years.

“In October of 2022 the 10 year yield was at 4.25 per cent. So you've been in a range for the last three years, and it's ebbed and flowed, because we've had a whole bunch of events that have made people more scared, causing bonds to rally and yields to fall, and made people more worried the other way, causing yields to rise, and yet you're very much rangebound,” Stonehouse says. “Maybe that's a sign that the bedrock, that faith in in the ability of the US to honour its debts, hasn't gone away.”