Scott Bessent and Kevin Warsh Ordered the US Bond Curve and There Was No Tantrum Over the Upcoming Rate Hike

There was no standoff between the Treasury and the bond vigilantes. There is no worse wedge than one made of the same wood. A veteran of the trade, Scott Bessent knows where the shoe pinches. Long-term rates are in order, he must have informed President Trump. Public debt, however, is not. But that is only the geography of the problem. It was never the reason for the tangle. Long-term rates have stopped climbing. There was no tantrum from the bonds, the feared tantrum. They respected the line in the sand that the Treasury Secretary suggested (even though he did not draw one). The 30-year rate did not step back to 5.34%. On Friday, it dropped to 5.17% after listening to the Fed chairman's harsh speech in Jackson Hole. Although it closed higher, at 5.21%, after reconsidering.

The 10-year rate, which is the relevant one, even though it was not directly mentioned, settled just shy of 4.75%. Challenging, if you will. Even so, it did not disregard Bessent's will. He did not dare to take a small step forward. Perhaps convinced that the path is upward, but winding, without ruling out an abyss ahead. And the Treasury has not yet spent the coin it promised. Only next Wednesday will it make the first buyback of old debt, in an expanded auction from 2 billion dollars to 4 billion. It will be one drop less in the ocean of public debt. Which will need to be replenished later. That is, financing by issuing new liabilities.

How is it that Bessent dictates to the markets how far they can go? He does it like Mario Draghi. The secretary, who is taking on increasing responsibilities in the Trump Administration, whether to put out fires or focus on resolving bottlenecks, had a work-heavy week. He did not want to argue with the bond vigilantes. He let them accumulate arguments against him, but on Monday he put the sword's width on the table. The buybacks he announced total 14 billion dollars. However, that is not all. If necessary, he hinted, he could tap into the trillion dollars that the Treasury has deposited in its general account at the Fed. He exaggerated, though only by a handful of dollars. In other words, he warned that the "whatever it takes" principle applies. Just like when Draghi, at the helm of the ECB, had to cut the run against the euro. And as the saying goes: a bird in the hand is worth more than a hundred flying. The trillion in cash weighed more than the 40 trillion in obligations in the air (or 32 trillion if intra-public sector holdings are netted). This is how the bond vigilantes understood it. And they canceled the anticipated standoff until further notice. We warned before Bessent: this is the gymnastics that the Treasury performs every time politics forces a government shutdown. Nothing that it does not know how to execute.

Bessent needed to anesthetize the bond vigilantes. He had to announce the new strategy that will be employed in the war in Iran. He first ensured the calm of the beasts. Only then did he launch the Economic Pariah operation. The White House seeks to isolate not only Tehran but also those who provide assistance to circumvent the blockade that will be imposed on it in all areas. The Treasury thus took over from Defense. Missiles are scarce. The martial spirit is waning. The offer of sanctions is elastic and vigorous. And Bessent, as a veteran financier, is the one who must weave his plot. The main risk for the bonds was an Iranian retaliation and the potential collateral damage in the energy market. But the price of crude oil fell significantly. Ormuz did not pay much attention to the announcements. The money trail revealed by the Treasury also did not alter the markets. The blacklist -- the Emirati branch of the Egyptian bank Misr, the manager of a bank branch in Dubai, and a small shell company in Hong Kong -- did not move the needle. "There will be unprecedented sanctions," Bessent had said. But what he has delivered so far is just more of the same. Thus, the war continues. Just as it continues in Ukraine since 2022. It has been six months (without celebrations or explosions). As long as energy prices do not soar, geopolitics is an anecdote and life goes on.

How far does the empire of the Treasury reach? It has already taken from the vigilantes the management of the last mile in the long end of the bond curve. What about the front end, the one that the Fed governs through monetary policy? The region where Bessent increasingly goes to finance himself. Who is in charge there? There were no doubts when Jerome Powell was at the helm. Trump never managed to impose his criteria on him. And with the new leadership of Kevin Warsh, Bessent's favorite when choosing his successor? The president always wants lower rates. Warsh kept them. The Fed became divided. Three district heads voted in dissent at the July meeting advocating for an increase. Others expressed agreement, but (this year) they do not have a vote to weigh in on the decision. The governors, for the most part, remain silent or do not touch on the subject. Powell, for instance, maintains absolute silence. It will be useful to hear Chris Waller on Thursday.

It is unclear what path the Fed will take. And this is by design. Warsh canceled forward guidance from his first day and cut communication. He mentioned his intention to produce significant changes in the institution, but he could not explain the basics: what was the reaction function that guided his steps. He did express his preference for listening to the genuine message from the markets, free from interference (including that which may arise from the central bank's own view). Well, since March, the markets have systematically raised their rates. Across all maturities. And already around 75 basis points. The Fed has remained still since December. It did not interfere at all. What part, then, has the new chairman not yet understood?

The July meeting concluded, and the yield curve, which had bought Warsh's hard anti-inflationary discourse and his sharp criticism of the management that allowed inflation to exceed the target since 2021, had to recalculate its position. It raised its rates even further, with a very marked exception at the short end. The two-year rate dismantled from its level of 4.35% (versus 3.75% of fed funds) and fell by 20 basis points. But the slope steepened. And long rates climbed vigorously. So much so that it forced Bessent to intervene to calm them. "They do not reflect the fundamentals well," he stated. The paradox is that the genuine message Warsh was receiving was abruptly interrupted by that sudden interference.

Never before has the Jackson Hole symposium been so timely. On Friday, Warsh took the stage to restore his credibility. He set aside his usual brevity. He spoke at length. He reestablished his hawkish credentials. He pointed out that current financial conditions do not seem restrictive to him. He stated that the moderation of inflation in June and July (facilitated by a drop in oil prices that has since evaporated) did not convince him of an improvement in the underlying trend. This is a speech that could be delivered by the three dissenters. He clarified confusions. The inflation target of 2% will continue to be measured by the personal consumption deflator. Short-term rates are the fundamental tool for the central bank to fulfill its dual mandate. There are no substitutes. And he concluded emphatically: the Fed has work to do if inflation does not decrease soon. The hawk has returned, although still clinging to the conditional.

Warsh's idea was to restore his tarnished image after the disorder of July. Mission accomplished. The short curve is in order. The two-year rate returned to its level of 4.35%. The dollar consolidated. However, long-term rates did not regain lost ground. Futures in Chicago are again pricing in a quarter-point hike in fed funds as the favored scenario for the September meeting. It is clear that if he is consistent, and truly wants to raise rates, a broad majority will support his motion. And the increase will become a reality. Futures see it as 60% likely. They do, however, maintain a 40% doubt. And not because they expect a quick drop in inflation. Before that, on November 3, the elections will arrive. And who knows what the real Warsh is? The speaker who talks like a convinced hawk. Or the actor who plays the role of a dove. That is the question. Bessent remains silent. But Trump provides forward guidance. He says it is "fantastic," that he does not want to raise rates, but faces a hostile board that may force him. If that were the case, if Warsh lost the internal vote and the Fed executed the increase, the chairman would have fulfilled another of his promises. To produce a Copernican shift in the central bank. The curve may be in order. The house, not. And that serves no one. We will know in two weeks.

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