Debt Markets Continue to Decline After the Fed’s Policy Blunders

By the Curmudgeon with Victor Sperandeo

Executive Summary:

As expected, the Federal Open Market Committee (FOMC) this past week unanimously voted (12 to 0) to raise its federal-funds target rate by 25 basis points (bps) to a range of 3.75%–4.00%.

The accompanying Summary of Economic Projections (SEPs) pointed to another quarter-point increase by December, implying a 4.00%–4.25% target range at 2026 year-end. The more consequential signal lies in the 2027 projections. The median year-end “dot” plot calls for no additional tightening beyond the expected December move. However, only seven of the 18 participants submitting projections supported that outcome.

In a client note drawing on prior public comments by Fed officials, Deutsche Bank economists concluded that next year’s voting cohort could divide sharply: five members may favor maintaining the policy rate through 2027, two could support an additional 25-basis-point increase, and four may favor rate cuts.

The usual caveat applies. All seven Federal Reserve Governors and the 12 Reserve Bank presidents are eligible to submit SEP projections, regardless of their voting status at a particular meeting. Chairman Kevin Warsh, a longtime critic of explicit forward guidance, again declined to submit a rate projection for the SEP dot plot.

Many Fed watchers labeled this week's meeting as "hawkish," but the more relevant judgment comes from the interest rates market.

· Fed funds futures are discounting a policy path materially higher than the Committee’s median projection.

· The 2-year U.S. Treasury yield is sending a similar message. It closed at 4.76% on Friday, up from 4.19% 30 days prior, and 3.38% on February 27, 2026, when the U.S.-Iran war started!

· DoubleLine’s Jeffrey Gundlach has repeatedly observed that the two-year note has provided a more reliable guide to the Fed’s eventual policy decisions than the statements of the monetary mandarins themselves. Here's a 1-year chart of the 2-year T-Note yield:

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Victor on the Fed and U.S. Debt Markets:

Since 1970, the Fed funds rate and the 2-year T-Note yield have had a 95% correlation. It is far more bearish to stretch out the rate increases, as it constantly puts the U.S. debt market on the defensive, instead of a one and done rate rise.

The action of the U.S. debt markets after Wednesday's Fed rate increase was as bad as it can get: a brief rally on Thursday, then a move to NEW LOWS on Friday on the 10-year, 5-year, and 2- year T-notes.

The steep decline in the price of U.S. notes and bonds (rise in yields) started in earnest after Fed Chairman Kevin Warsh took over on May 22nd. From the. May 28th to September 18th, the 10–year Treasury note yield increased 56 bps, or +12.6% (the 10-year yield went from 4.45% to 5.01%).

Before Warsh became Fed chairman, two rate cuts were expected this year, but now it's two hikes in 2026! Point of order:

· In 2024, the Powell Fed cut 50bps 2 months before the U.S. Presidential election with core CPI at 3.3%

· In 2026, the Warsh Fed hikes 25bps 2 months before the U.S. midterms with core CPI at 2.4%

Image Courtesy of Zero Hedge

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Importantly, FOMC members were very blasé’ about the rapid decline in U.S. Treasury note and bond prices? The rise in yields significantly increases U.S. debt financing costs, adds to the budget deficit, and increases mortgage rates (thereby making home buying even less affordable).

Warsh offered a sunnier interpretation of why Treasury yields have moved higher, citing increased expectations for economic growth and the artificial-intelligence investment boom, alongside geopolitical risks.

-->Victor says this is a mini bond market crash, yet no Fed member said a word about it. And it is happening before the very important U.S. elections in November.

-->The Curmudgeon, who has his entire Roth IRA in bond funds/ETFs and owns numerous U.S. government, corporate and muni bond funds in taxable accounts, says it is a MAJOR CRASH as every bond fund/ETF (even those with ultra short maturities) has a negative 5-year NAV return!

Is the U.S. Economy Really Strong?

After the FOMC meeting ended on Wednesday, Warsh said, “There’s been a pretty wide-ranging set of data, including the labor markets, that the economy has strengthened,” It was a point he emphasized throughout the press conference.

Yet many economists disagree with that statement. For sure, AI build-outs are very strong, but that's only 7% of the U.S. economy. Those AI investments help ~5-to-6% of major corporations (mostly hyperscalers) while other engineering firms benefit directly from AI data center construction, power, and the cooling needed.

Yet we believe the U.S. economy is weak and getting weaker by many metrics. For example, consumer income growth is only + 3%, the workforce declined by 2 million (as many workers were discouraged they could not find jobs, so the unemployment rate remained at 4.1%),

housing, and auto sales are crashing, GDP has averaged 1.5% (estimate) for last three quarters. Take a look at last week's economic reports:

· The National Association of Home Builders (NAHB) Builder Optimism Index dropped from 35 to 32 in September as sales expectations plummeted. The market continued to struggle as 38% of builders cut prices an average of -6% and two-thirds of builders used sales incentives.

· The new construction housing report from the Census Bureau reported that Housing Starts fell -2.6% and Building Permits dropped -2.7%.

· Pending Home Sales remained near all-time lows as they ticked up 0.3% in August. The market remains muted as high mortgage rates continue to dissuade buyers.

· The Leading Economic Index (LEI) declined -0.1% in August as consumer expectations and building permits pulled the Index lower.

· The University of Michigan Survey showed the U.S. index of consumer sentiment dropped to 47.8 in September down from 51.7 in August, driven by rising fuel prices and trade tensions.

· Rising energy and utility prices are actively shrinking American savings an spending. This financial strain forces households to re-evaluate discretionary spending and forego unnecessary travel.

Energy Shock Revisited:

The oil market has acquired a far more dangerous geopolitical premium. Saudi Arabia’s reported shutdown of the east–west crude pipeline to the Red Sea—after Houthi drone and missile attacks—materially raises the risk to regional supply and export logistics. It also exposes the vulnerability of the House of Saud at a moment when internal succession, tribal loyalties, and elite rivalries remain consequential.

If the disruption is sustained, this is no longer simply an oil-price story. It becomes a regime-risk and global-growth story. Saudi Crown Prince Mohammed bin Salman’s political position could be tested precisely as the kingdom confronts heightened security threats and an oil-market shock. As a result, diesel fuel has hit $9/gallon in the SF Bay Area while regular unleaded gas is over $6/gallon. The timing couldn't be worse- it's just a few weeks before the November midterm elections. See Political Transmission section below.

The Fed’s Policy Error vs. Iran War Driven Oil Shock:

The critical error is the Fed’s apparent refusal to distinguish between a war-driven oil shock and broad-based, demand-led inflation.

An abrupt oil-supply disruption raises the price level, but it does not necessarily create a self-reinforcing inflation cycle. Treating a temporary geopolitical price spike as persistent inflation—and responding with additional rate increases—risks converting an external supply shock into a domestic recession.

The comparison with 2008 is instructive. As we've noted in several previous posts, the Fed cut rates four times while oil moved from roughly $95 to $147 per barrel (mostly due to the mortgage meltdown). Today’s Fed appears prepared to do the opposite: tighten into an energy shock, weaken credit conditions, and place further pressure on consumers and corporate borrowers.

Iran’s stated desire for retaliation against President Trump adds another layer of geopolitical risk. Oil and refined energy product prices could remain elevated through the November elections, especially if the conflict broadens, export infrastructure remains impaired, or shipping risks worsen.

Political Transmission:

The electoral implications are immediate. Gasoline prices are among the few economic indicators voters experience directly and repeatedly. A sharp rise at the pump would further pressure the Republican Party’s already fragile political position. The Drudge Report summarized the risk: “Pain in the gas prices set to spike—Dems 83% chance to take the House, 54% Senate.”

-->Conservative pollster Richard Baris (of the Big Data Poll) was even more blunt: “We (the GOP) will be slaughtered.”

That assessment preceded the latest tightening signals from the Federal Reserve. The political damage compounds if markets and voters conclude that President Trump selected a Fed chairman who is now pursuing a policy agenda at odds with the administration’s economic objectives.

What About the Fed’s Balance Sheet?

Kevin Warsh built his credibility on the argument that shrinking the Fed’s balance sheet would restore monetary discipline and, ultimately, enable lower interest rates. Yet he has not emphasized balance-sheet reduction since taking office with the Fed's balance sheet at $6.747 trillion- up slightly since Warsh took office!

A genuine runoff program would tend to tighten liquidity, pressure equities, and—over time—potentially support bonds. Instead, markets are hearing a simpler message: "higher rates for longer." The interest rate markets have been repricing that message.

Credit Is Already Warning:

The deterioration in lower-quality credit is increasingly difficult to dismiss. Investment-grade and high-yield bond ETFs—including LQD, HYG, and JNK—have fallen to new 2026 lows. If QI Research is correct that bankruptcies are up 64% year over year, credit stress is no longer theoretical; it is moving into the early stages of a broader economic and market breakdown.

As respected economist David Rosenberg has argued, the rise in yields is not principally a fiscal-deficit story or an inflation-expectations story. TIPS yields do not support that explanation. The central issue is a reset in expectations for Federal Reserve policy.

In Rosenberg’s formulation, roughly two-thirds of the yield increase followed the three occasions on which Warsh publicly shifted market expectations. That is the market’s verdict: rates are rising because investors now expect a more restrictive Fed, not because inflation expectations have broken loose.

The lesson is credibility. Never trade political promises as though they are binding policy commitments. Governments say what is necessary to obtain power; markets eventually discover what they will actually do.

Raising rates and producing a recession is disingenuous. Any 16-year-old can understand that tighter money depresses credit, housing, capital spending, and employment. The difficult task is reducing inflation without crushing the economy. That was the promise. It is not what the interest rates and debt markets are now pricing in.

Victor's Investment Position and Market Comments:

I am selling my 5-year Treasury note futures at a loss and shorting the S&P 500, with stops above new highs. This is not a casual trade. It reflects a conclusion I did not expect to reach during an election year: the Fed and the White House appear to be misreading the economic and market consequences of their own policies.

The equity bull market that began in March 2009 was built on declining rates, abundant liquidity, expanding multiples, and a prolonged suppression of credit risk. Those foundations are being challenged simultaneously:

· A geopolitical oil shock is raising input costs and impairing real household income.

· Fed policy is tightening financial conditions rather than cushioning the shock.

· Credit spreads and lower-rated debt are deteriorating.

· Corporate bankruptcies are accelerating.

· The political system is heading into an election with gasoline prices moving in the wrong direction.

Absent a decisive policy reversal beginning after September 16, 2026, a 50% decline in equities is no longer an implausible tail risk. It is becoming a credible bear-market scenario.

Conclusions:

The U.S. interest rate and debt markets are way ahead of the FOMC pricing in a "higher for longer" scenario:

· Fed Funds futures (via the CME’s Fed Watch Tool) imply three additional 25-bps increases by the end of the December 8, 2027, Fed meeting. There's a 31% probability that the Funds rate will be in a target range of 4.50%–4.75% at that time.

· The 2-year U.S. Treasury yield, at 4.76%, reinforces the belief in a higher terminal policy rate than the Fed’s dot plot acknowledges.

· The 10- and 30-year U.S. Treasury yields are at multi-decade highs (prices are at 20-year lows).

That rate gap is important. Either inflation proves persistent enough to force the Fed to ratify the market’s more restrictive path, or the economy weakens enough to validate the Committee’s less aggressive forecast. History suggests that when policymakers and the bond market disagree, it is usually the Fed that eventually adjusts.

The high oil and gas prices will have a significant impact on the November elections. History shows that when energy prices climb, the incumbent party (now the GOP) usually loses the election. That's what many pollsters are now forecasting.

End Quote:

A lesson for us all from Hannah Arendt (Oct 1906 - Dec 1975),

German historian and philosopher:

Wishing you good health, success and good luck. Till next time.................

The Curmudgeon
ajwdct@gmail.com

Follow the Curmudgeon on Twitter @ajwdct247

Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever-changing and arcane world of markets, economies, and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.

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