In his first few months as chairman of the Federal Reserve (Fed), Kevin Warsh, has reset several practices that markets have grown accustomed to over the past 15 years. The Fed is reviewing its policy framework and balance sheet, pulling back on forward guidance, and placing more emphasis on letting economic data and financial markets speak for themselves. At the July Federal Open Market Committee (FOMC) meeting‡, the Fed held rates steady and did not offer forward guidance on what comes next.

During a post-meeting press conference, Warsh summed up the shift nicely: “Markets are learning to play the ball, not the referee.” That line may also be the best way to think about the yield curve today.

For years, markets have spent an enormous amount of time parsing every Fed speech, dot plot and press conference for clues about where rates are headed. Warsh appears to want less of that—less forward guidance, less dependence on the Fed, and more price discovery based on the economic data itself.

For bond investors, that distinction matters. The Fed still controls the short end of the curve. However, further along the curve, investors need to keep an eye on the ball.

The Fed still controls the short end

Monetary policy primarily determines short-term interest rates. The Fed uses the federal funds rate to influence economic activity—raising rates when the economy runs hot and lowering them when the economy needs support.

Congress gives the Fed a dual mandate that charges the central bank to use monetary policy to achieve two primary goals: maximum employment and price stability. The Fed targets a two percent inflation rate for price stability. When inflation rises above target, the Fed may need to tighten policy or raise rates. If inflation falls and growth weakens, the Fed has more room to ease conditions.

This dynamic gives the Fed tremendous influence over the front end of the Treasury curve.

So, watching the referee still makes sense at the short end. However, the further we move out the curve, the less control the Fed has over rates.

Farther out, watch the ball

Longer-term interest rates, such as the 10-year Treasury, reflect far more than expectations for the next Fed meeting scheduled for mid-September. Investors weigh inflation, economic growth, future short-term rates, fiscal policy, Treasury supply, and the return they require to take interest-rate risk for the next decade. The Fed can influence those expectations, but it can’t dictate them.

This matters most when the Fed lowers short-term rates while longer-term yields remain elevated. No rule requires the 10-year to follow the federal funds rate lower.

If investors believe inflation will remain sticky, economic growth will hold up, or large federal deficits will require significantly more Treasury issuance, they can simply demand a higher yield.

Economist Ed Yardeni coined the term “bond vigilantes‡” in the 1980s to describe this dynamic. When investors dislike what they see from monetary or fiscal policy, they vote with their feet—selling bonds until yields reach a level that adequately compensates them for the risk.

Put simply, the Fed sets the overnight rate. The market sets the price of lending money for 10, 20, or 30 years into the future. The difference is often referred to as the “term premium.”

When the Fed was more than the referee

Quantitative easing blurred that distinction.

Following the financial crisis and again during the pandemic, the Fed purchased massive amounts of Treasuries and mortgage-backed securities. Those purchases added demand to the market and helped push longer-term yields lower.

Through these emergency measures, the Fed not only set short-term policy but also actively influenced prices further out on the curve. As conditions normalize and the Fed steps back from that role, normal supply-and-demand dynamics begin to matter more.

Today, deficit spending ranks among the largest forces pushing sovereign debt yields higher. Large federal deficits require more Treasury issuance, and buyers must purchase those bonds. If supply grows faster than demand, yields may have to rise to attract capital. When you add inflation expectations, economic growth, and term premium, the long end can tell a very different story than the federal funds rate.

What is the curve telling us?

Warsh’s comment becomes particularly relevant here. Short-term rates tell us a lot about the Fed. Long-term rates tell us more about the economy and the market’s assessment of risk.

Right now, the curve tells us that owning long-term bonds requires a risk premium.

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About the authors:

Francis Scheuerman is senior vice president and investment officer at UMB Bank, Capital Markets Division. He offers transaction and portfolios services for banks, institutions, and financial advisors throughout the Midwest.

James Carlile is vice president and an investment officer at UMB Bank, Capital Markets Division. He is responsible for helping institutional clients understand how to best manage their bond portfolios and interest rate risk.

Javier Garcia is an investment officer at UMB Bank, Capital Markets Division. He is responsible for working with banks and institutional clients regarding interest rate risk management and fixed income portfolio strategies.

Mark Neff is a senior vice president at UMB Bank, Capital Markets Division. He assists institutional clients with fixed-income strategies, interest rate risk management, oversees liquidity management and provides bond market analysis.

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