Reprogramming the Fed's Reaction Function

The month following Fed Chair Warsh's first meeting has seen no shortage of drama, as U.S./Iran hostilities resumed (then paused again), inflation surprised to the downside, and the market ascribed an increasing probability of near-term hikes in the absence of forward guidance. The probability of a Fed hike in July exemplifies the new reality of Fed policy: the odds of a rate hike at the July FOMC meeting surged to 39% after Warsh's first FOMC meeting, fell, rose again to 43% following the resumption of U.S./Iran bombings, plunged to 10% after the most recent CPI release, and now stand at 38%, one day before the next meeting begins. While our base case remains that the FOMC holds rates steady in July, the push and pull between easing shelter inflation and uncertainty surrounding elevated energy prices following the closure of the Strait of Hormuz have left the market assigning meaningful odds to a rate hike under a potentially more adaptive Warsh Fed. Investors will likely focus as much on Warsh's press conference as on the policy decision itself, searching for clues about the committee's reaction function, even if he avoids offering explicit guidance to markets.

Long-term interest rates remain driven more by Fed expectations and less by fiscal sustainability concerns, a notable reversal from last year. While the 10-year Treasury yield has moved higher in 2026, the increase has been driven primarily by investors raising their expectations for the future path of Fed policy rather than demanding greater compensation for long-term fiscal risks. Our base case remains that the Fed holds steady when it concludes its meeting this week. The more notable takeaway is what this month has revealed about the mechanics of rate markets under the new Warsh regime. With forward guidance largely absent, interest rates have become far more sensitive to spot movements in Fed expectations, repricing sharply with each data release. That sensitivity cuts both ways. A few more favorable inflation prints, combined with a de-escalation in the Strait of Hormuz, would remove much of the upside pressure that has kept hike probabilities elevated and could pull the yield curve lower in short order.