Since March, when the US Congress began considering Kevin Warsh’s appointment as Chairman of the Federal Reserve, bond yields have surged 75 basis points. Initially, financial markets were concerned about Mr. Warsh’s ability to resist inevitable pressure from POTUS47. In particular, would he take a dovish approach to controlling above-target inflation. These fears intensified after his comments following the FOMC’s July meeting.

Markets, particularly the so-called bond vigilantes, have a way of educating misdirected policymakers (investors are also not immune). And, Chairman Warsh’s speech at Jackson Hole suggests he got the message. He emphasised the Fed’s priority is to lower US inflation towards the central bank’s 2% target; potentially leading to rate hikes in September, and perhaps even December.

Nonetheless, Mr. Warsh’s continued scepticism about the efficacy of “forward guidance” indicates he has not fully accepted the bond market’s verdict. As a result, despite financial markets’ initially positive reaction to the Chairman’s speech, I anticipate US bond yields will rise further, and market volatility to increase in coming months.

Likewise, Treasury Secretary Scott Bessent may also have lessons to learn. His recent attempt to engineer lower bond yields ended in predictable failure. Perhaps inevitably, bond vigilantes may send him and the Trump Administration the message that only a credible deficit reduction plan will calm financial markets over the long term.

What’s Driving the Bond Market Turbulence?

Identifying the drivers of the recent rise in bond yields may help us predict their future direction. First of all, surprisingly, despite higher oil prices and the rise in overall inflation resulting from the Iran war, long-term inflationary expectations have remained pretty well anchored (Chart above).

The rise in long-term interest rates, therefore, has resulted from higher “real” yields (Chart above). Usually, rising inflation-adjusted yields reflect strong private and public sector demands for credit. While US economic growth has been resilient, GDP growth is only around the 2% long-term trend potential. However, private sector credit demand has surged, led by booming AI infrastructure investment. In addition, the untamed 6% of GDP US Federal government budget deficit have sustained elevated public sector credit demand.

Rising real bond yields also reflect investor uncertainty, which can also be reflected in a steeper yield curve. Indeed, the larger “term premium” accounts for all of this year’s rise in long-term interest rates. I believe Mr Warsh’s decision to not provide forward guidance is the primary driver of rising US bond yields and the markets’ demand for increased compensation when buying long-term bonds.

What’s Next: Economic Growth to Slow

Despite claims about a booming American economy, US GDP only is growing in line with its long-term potential of about 2 to 2-1/4% this year. Moreover, the expansion remains unbalanced, and highly reliant upon surging AI investment and resilient spending in affluent households. To be sure, very healthy corporate profitability suggests that capital spending should remain healthy (Chart above).

Against this promising background, the FOMC forecasts GDP growth will continue to expand in line with its long-term trend in both 2026 and 2027. I am less optimistic. The recent resilience in US consumer spending has resulted largely from a fall in the savings rate, which is now near record lows. Meanwhile, high energy prices and overall inflation are causing household incomes to stagnate (Chart above). If the Iran war continues for another six months, I expect a meaningful deceleration in household spending and GDP growth next year.

Inflation: Will Remain Above Target in 2027

Chairman Warsh correctly committed to lowering price growth to the Fed’s 2% target. However, this might take longer than hoped for. Indeed, while July’s 3.7% YOY rise in PCE inflation is worrisome enough, rising energy led an acceleration in price growth to 4.1% during the past six months. Meanwhile, the Fed’s favoured measure of “core” inflation advanced 3.4% during both the past 6 and 12 month intervals.

Inflation optimists point to decelerating advances in wages and unit labour costs. I agree: ULCs increased only 0.3% in Q2 2026. To be sure, there’s a strong link between labour costs and price increases (Chart above). However, the relationship breaks down when labour’s negotiating position is weak, e.g in the 1980s/90s after NAFTA and China’s opening and during Covid. AI’s potential to weaken labour: boosting corporate profits and weakening the link between wage and price growth.

To be sure, AI has the potential to lift productivity and curb inflation over time. At this stage, however, while productivity growth has improved recently, it’s not yet obvious that output per hour growth is on a stronger long-term trend (Chart above). Overall, therefore, unless the Iran war ends soon, I expect “core inflation remain above target — in the 2.5%-3% range by the end of 2027.

Fiscal Policy: Mr. Bessent’s Education

Predictably, the benefits of Treasury Secretary Bessent’s attempt to manipulate US bond yields were short-lived. Worse, the proposal of such gimmicks gives the impression the Trump Administration does not grasp the seriousness of America’s fiscal problems.

The CBO projects annual budget deficits of 6% of GDP during the coming decade. Even worse, America’s debt ratio is not only high, but will continue to rise in the coming period. To be sure, the United States is not alone: China and other advanced nations have confront formidable challenges. However, America’s position is amongst the most serious (Chart above).

Global bond markets have been surprisingly relaxed so far, but this could change quickly. As a starting point, the USA must reduce its primary budget deficit (not including interest payments) by 3-4% of GDP simply to stabilise its debt ratio over the medium term. Without deep spending cuts on entitlement programs (especially social security and Medicare), either taxes will need to rise or non-defence discretionary spending will need to be eliminated completely (every cent). The political for such action does not exist. Mr. Bessent may discover that bond markets may revolt against inaction eventually.

Monetary Policy: More Work To Do

At Jackson Hole, Chairman Powell indicated inflation would be the Fed’s priority. With unemployment low (despite tepid job growth) and inflation remaining elevated, monetary policy still appears to be accommodative; that is, the Fed funds rate has not even reached a “neutral” setting. The Chairman correctly observed the central bank “had more work to do” to achieve its 2% inflation goal.

As a result, I expect the FOMC to hike interest rates in September, and possibly again in December. I also expect 10-year yields to reach 5-5.25% in the coming months. Eventually, however, slowing growth and declining inflation will cap the rise in bond yields. in 2027.

However, the possibility of a fiscal crisis remains a wild card. Following the Jackson Hole speech, the US yield curve flattened, largely reflecting a reassessment of the risk of additional monetary tightening. This may continue through the end of 2026. However, the Chart above indicates the US yield curve is not particularly steep. Indeed, it’s flatter than Germany’s; whose budget deficit is smaller. Perhaps the US curve should be similar to Italy and France whose fiscal situation is more comparable to the USA. A fiscal crisis would lead to a much steeper curve and higher bond yields in 2027.

Market Implications:

This year’s 12% rise in the S&P 500 fully reflects the amazing surge in US corporate earnings per share (admittedly the EPS performance has exceeded my expectations). Indeed, as a result of higher bond yields, inflation, and uncertainty about American monetary and fiscal policies, the market’s Price/Earnings ratio has declined.

Currently, the Chart above illustrates US stocks are fairly valued relative to bond investments (the Chart is provided by Yardeni Research). At present, the S&P 500 already trades at 19X consensus’s 2027 EPS estimates. However, if the US economy slows, as I expect, EPS growth may fall short of the consensus’s optimistic 10% estimate. Therefore, if bond yields rise meaningfully above 5% in the period ahead, equity values may struggle to advance much further, as the the P/E ratio contracts again. Better opportunities may exist in international markets. If I’m wrong, however, and consensus EPS estimates are achieved and bond yields decline to 4.5%, the S&P could enjoy another double-digit gain through 2027.