Fed's Inflation-Fighting Credibility Questioned as 30-Year U.S. Treasury Yield Hovers Near 2007 High

U.S. long-term Treasury yields remained elevated on Thursday (30th), with the 30-year Treasury yield briefly reaching 5.21%, hovering near its highest level since 2007. Wall Street analysts say the market is questioning the Federal Reserve's determination to combat inflation, with investors demanding higher term premiums to hold long-term U.S. Treasuries.

On Thursday, the 10-year Treasury yield rose to 4.66%, while the 30-year yield hit 5.21%. The 30-year yield rose 6 basis points after the close of normal trading on Wednesday, briefly surpassing 5.2%. Yields across other maturities saw relatively limited movement on Thursday.

The Federal Reserve voted 9 to 3 on Wednesday to keep the federal funds rate unchanged in the 3.5% to 3.75% range. This was the second Federal Open Market Committee (FOMC) meeting chaired by Powell since he took office as Fed Chair.

In its post-meeting statement, the Fed said that despite high uncertainty in the economic outlook due to factors like the Middle East conflict, U.S. economic activity continues to expand at a solid pace. Employment growth has broadly kept pace with labor force growth, and the unemployment rate has shown no significant change.

However, bond market reactions to the decision were mixed. During Powell's press conference on Wednesday, the 2-year Treasury yield fell by 4 basis points, while both the 10-year and 30-year yields rose.

According to Wall Street institutions, falling short-term yields alongside rising long-term yields reflect market concerns that the Fed may be falling behind on inflation. As a result, investors are demanding higher term premiums to compensate for inflation risks associated with holding long-term bonds.

Bank of America: Market Experiencing an 'Inflation Credibility Shock'

Economists Aditya Bhave and his team at Bank of America Global Research noted that the market's post-meeting reaction shows characteristics typical of a central bank facing an 'inflation credibility shock'—where investors begin to doubt the central bank's ability to control inflation.

Bank of America believes that to restore market confidence, the Fed may actually need to increase the likelihood of a rate hike in September. Assuming other conditions remain unchanged, the bank forecasts the Fed will raise rates by 25 basis points at each of its remaining three meetings this year, totaling three quarter-point hikes.

Traders on the prediction market Polymarket increased the probability of a Fed rate hike in September to 56% following Powell's press conference.

Powell has previously stated he does not intend to provide clear forward guidance, preferring that the market interpret economic data and policy signals on its own. Although he reiterated the Fed's commitment to bringing inflation down to the 2% target, Bank of America economists believe Powell's limited messaging during the press conference was overall somewhat dovish.

Powell said the Fed continues to use the Personal Consumption Expenditures (PCE) price index as its primary inflation gauge, but indicated that it may adjust its measurement approach following recommendations from a newly established data review task force.

Bank of America warns this statement could give the Fed more room to select metrics favorable to looser policy, potentially undermining consistency in policy communication.

Tighter Financial Conditions Cannot Replace Actual Rate Hikes

Powell also suggested that raising interest rates is not the only tool to combat inflation. As long-term U.S. Treasury yields have risen in recent weeks, mortgage and corporate financing costs have increased, effectively tightening financial conditions on behalf of the Fed.

However, Bank of America analysts argue the Fed cannot rely solely on hawkish rhetoric to let the market do the tightening work over the long term. Ultimately, the central bank must take policy actions consistent with its messaging; otherwise, its credibility could be further damaged.

Wall Street institutions are divided on the magnitude of future rate hikes. Bank of America forecasts the Fed will raise rates by 25 basis points at each of its remaining three meetings this year. Deutsche Bank, however, expects a total of 50 basis points in rate hikes this year.

Deutsche Bank notes that rising long-term yields and falling forward real yields suggest investor skepticism about a swift return to price stability, making it unlikely the Fed would be comfortable with such market reactions.

Deutsche Bank believes the overall U.S. credit environment remains supportive, but a further steepening of the yield curve could加重 pressure on an already weak housing market.

Economic Growth Slows While Inflation Remains High

Data released on Thursday showed U.S. second-quarter economic growth slowed to 1.5%, below the market expectation of 1.8%.

Inflation remains above the Fed's 2% policy target. The core PCE price index, excluding food and energy, rose 0.1% month-on-month, below the expected 0.2%; the year-on-year increase was 3.3%, in line with market forecasts.

With economic growth cooling and core inflation still above target, the Fed's policy trade-offs have become more complex. The market will now watch whether the Fed needs to raise rates in practice to reaffirm its credibility in fighting inflation.