New Highs, Higher Yields, and a Weaker Dollar. Can All Three Persist?

Despite renewed inflation and deficit concerns, ongoing geopolitical conflict, and a hawkish tone from Chair Warsh at Jackson Hole, equities moved higher in August, supported by a rebound in mega-cap technology.

The Nasdaq Composite gained 4.0% and the S&P 500 rose 2.7%, each posting its first monthly advance since May, while both the S&P 500 and the Dow Jones Industrial Average reached record highs during the month.

Emerging market and international developed equities led (+3.3% each), followed by US growth (+3.2%). Aside from municipal bonds (-0.2%), fixed income was mostly higher as high yield credits rose 1.0%, investment grade corporate bonds gained 0.4%, and the US Aggregate Bond Index increased 0.3%.

Commodities produced positive returns as silver surged 14.8%, gold gained 9.9%, broad-based commodities rose 7.4%, and crude oil increased 3.5%.

At his first Jackson Hole symposium as Fed Chair, Kevin Warsh struck a distinctly hawkish tone, putting price stability at the center of the Fed’s mandate and recommitting to its 2% inflation target.

“It is the Fed's job to deliver stable prices, no excuses,” he said, calling the goal a firm and fixed target.

He described the employment side of the mandate as in good shape, viewing the labor market as consistent with full employment at a 4.1% jobless rate and attributing soft job gains to slow labor-supply growth rather than weakening demand.

He also struck an optimistic note on growth, citing faster-than-expected progress in AI as lifting the economy's potential.

Inflation was his central concern. Summer readings had come in cooler, with July CPI at 3.4% year-over-year and core CPI easing to 2.5%, but the Fed's preferred gauge stayed firmer, as headline PCE ran 3.7% and core PCE 3.3%, both well above the 2% target.

Warsh seized on that gap, noting that “while this summer's readings were better than expected, they do not tell me that underlying trends have meaningfully improved,” and warned the Fed would have “work to do” if it could not be confident inflation was heading back to its goal.

As he has at every meeting since taking office, Warsh declined to offer forward guidance, arguing that pre-committing to a rate path narrows the Fed's room to maneuver.

Markets moved quickly, as short-term yields moved higher while longer-term yields declined, flattening the curve.

Ahead of the September FOMC meeting, the CME FedWatch Tool had assigned roughly a 70% probability to a hold before the speech. Markets now price a roughly 66% chance of a hike.

The broader backdrop for markets is a shift in the bond-market regime. After nearly four decades of generally falling interest rates, the long secular decline in Treasury yields has reversed since 2020, and that shift was on display this month as the 10-year yield reached topped 4.75%, its highest level since 2007 (Exhibit 2).

The move reflects persistent inflation, higher oil prices, and growing attention to the federal government's borrowing needs.

In response, the Treasury announced on August 19 that it would at least double its long-dated bond buybacks, from $2 billion to $4 billion per operation, funded through shorter-term bill issuance and the Treasury General Account.

These buybacks are meant to support liquidity by purchasing older, less-traded securities, and while they change the composition of Treasury debt and add a source of demand for long-duration bonds, they do not reduce the government's overall borrowing needs or debt outstanding.

The effect resembles quantitative easing (QE) in supporting bond demand, tho...