Is the Bond Market Overreacting?

As Treasury bonds take out the highest yield levels since the early 2000s, there is no scarcity of headlines hitting the tape. Treasuries have been trading like a risk asset. The long end of the curve has not liked lower policy rates since the Fed began cutting back in September 2024. The Fed cut rates with inflation trending in the right direction, but still above target: back then core CPI was at 3.2%, and Core PCE was at 2.6%. We believe the policy mistake isn’t the hike, but it was cutting interest rates so much in 2024 and 2025, leading to an inflation fatigue of 66 months above target inflation, which appears to be leading the Fed (and market) to overreact. We’ll make the point as to why we think the current market pricing is an overreaction of the underlying data.

Fed Fund Expectations

It’s no secret that the bulk of the move higher in interest rates can be attributed to a higher Fed policy rate, given strong underlying growth and not runaway inflation expectations. However, when we see the market assessment of future policy diverge from what the Fed is communicating, our antennas go up. There’s an old Wall Street saying that something should get your attention when there’s a gap between perception and reality.

To preface this note: We aren’t discounting that inflation is above target and has been for 66 months and counting. The fiscal + stimulus experiment run by the government has backfired with an ugly sequence of inflation. Our point in putting this together is:

1. The backdrop for inflation hasn’t really gotten worse than it was 6 months ago

2. Supply shocks should be overlooked by policymakers, especially given that inflation expectations are anchored

3. There are enough areas of the market where rates ARE restrictive

We’re as disappointed as everyone else in the inflation of the past 5 years; we just don’t believe the Fed making emotionally charged decisions leads to the best policy outcomes. To us, it’s a “why now?” question. This note challenges some of the media talking about inflation being unanchored or getting out of control with a good look at the data and what actually drives inflation.

We all know Inflation isn’t a new phenomenon. It’s been around a long time under every political regime.

Bond Supply

Many of these factors, such as the One Big Beautiful Bill (“OBBB”) as well as the tax cuts and refunds for the consumer, were well documented coming into 2026 as boosts to GDP growth. While AI-related capex (and the debt to finance it) was expected to be robust, it has been even higher than anyone expected. Can these factors continue?

Hyperscale issuance is helping put 2026 on course to surpass 2000 as the record year for US Corporate Investment Grade net supply. However, the demand for this debt has also been very high. The problem for the Treasury and Fed is that these borrowers are fairly price-insensitive, even at higher borrowing costs, given these companies are making durable, long-term investments they believe will produce 20+% returns in the future. The difference between 5% and 7% debt service cost with minimal outstanding debt to this point is trivial for companies doing billions in profit. Hyperscaler issuance has created a large supply of longer-duration debt, likely crowding out other borrowers like the US Government. We don’t think the Fed should aggressively move policy rates when other areas of the demand picture across the economy are already being impacted by restrictive rate policy.

The graphic above shows the bulk of growth in U.S. construction right now is data centers. Nearly everything else is shrinking. Data center spending this year has surged (understandably); power has also increased (to provide electricity to the data centers), while every other category is shrinking. The key takeaway is the construction economy is lopsided. One category, data centers, is booming while homebuilding, offices, factories, and most other building types are pulling back in real terms. Without the data center surge, overall construction would look much worse. To be fair, the above analysis doesn’t include public spending, which is huge and has been high, and doesn’t account for some of the roll-off from the CHIPS Act and other stimulus measures.

Is this really the environment you want to make policy even more restrictive in?

Inflation Data isn’t Worsening

There has been far less inflation in the third quarter than the second, as seen in the chart of the three-month-on-three-month annualized change in both headline and core PCE, both of which dropped to a two-year low. The bulk of the improvement was in June and July, but August was good enough to keep the improvement going. Most of the spikes were understandable given the spike in oil prices and the associated pass-through since the Iran conflict began in late February. With inflation trending in the right direction, it is now the time to get aggressive with rate policy, especially considering the Fed typically (and should) look through energy shocks.

Inflation Momentum Indicator

Warsh has mentioned his preference for a momentum inflation indicator that looks at the percentage of the 199 PCE components rising faster than 3%.

He noted that while 54% of components were up more than 3% in the 12 months ending in June, only 49% were up that much at an annual rate in the six months ending in June. Again, trending in the right direction.

PCE Inflation Methodology Changes

A key line in the just-released FOMC minutes yesterday was, “Under the new methodology that the Bureau of Economic Analysis (BEA) had announced would be implemented at the end of September, the staff estimated that total inflation would be 3.6% in August, with core inflation at 3.2%.” The actual core number was 3.0%, i.e., it was better than expected. That should help reinforce 1) the Fed can skip the rate hike in October and 2) this is not an aggressive rate hike cycle in 2026/27. This confirms our expectation that the market is overpricing the chances of the need for more rate hikes this year and next. These methodology changes should bring PCE and CPI closer together, a major talking point this year given the discrepancy.

Inflation Comps – Base Effects Improve Next Year

The trailing monthly run-rates are about 0.17 (3-month) and 0.23 (6-month) for core PCE, and 0.16 (3-month) and 0.21 (6-month) for core CPI. The core PCE is running at 3.01% YoY, while Core CPI is 2.45% YoY.

We sourced some illustrative paths to show how run rate numbers could impact the YoY numbers for Core PCE. Each assumes the same monthly change every month from September 2026 onward. It’s rudimentary but helpful in showing what could happen.

For Core PCE, the next three months have unfavorable base effects. September through November 2025 comps are soft, averaging about 0.19%. Any print near the 0.25% six-month pace will push the YoY up to roughly 3.2% by November. However, the December through May comps are much hotter, averaging about 0.32%, so we can expect the YoY number to fall sharply in early 2027. If monthly prints come in at 0.20% over those six months, the YoY rate falls by about 0.7 points for core PCE (1.90 cumulative rolling off versus 1.20 coming on) and about 0.3 points for core CPI (1.53 versus 1.20). The PCE drag is much larger because early 2026 PCE ran hotter than CPI. Should the Fed be hiking if the inflation picture is improving?

Economic Growth in Split Governments

While the polls show a Blue Wave in the midterms, we cannot know what plays out. However, we do know that historically economic growth tends to decelerate when moving from a single-party sweep to political gridlock because major fiscal stimulus, spending packages, and tax overhauls become much harder to pass.

A 2021 Oxford study found that average real GDP growth was about 3.7% under unified government vs. 2.3% under divided government. While we can attribute some of this year’s growth to Trump’s One Big Beautiful Bill, the depreciation allowances, and tax refunds, it’s unlikely to be the same boost in years ahead. If growth slows because of more political gridlock, should the Fed be raising interest rates?

No Wage Spiral

Historically, inflation only becomes self-sustaining when it feeds into wages, and that isn’t happening. Average hourly earnings for all employees on US private nonfarm payrolls have increased by ~3% YoY in September 2026, the least since May 2021, following a 3.1% advance in August and below the expected 3.2%.

The most recent reading for September 2026 is 3.02% YoY — down sharply from the post-pandemic peak of 8.1% in April 2020 and the 2022 cycle high of ~5.9%. The trend since mid-2022 has been consistently downward, with the rate now sitting near pre-pandemic norms of 2.5–3.5%.

In addition, the September payrolls rose only 29,000 and unemployment ticked up to 4.2%, with negative revisions for the prior two months, not exactly a red-hot labor market.

Comparing Today to the 70s is a Bad Analogy

As opposed to the 1970s (unionized labor, COLA clauses) or 2021-2023 (surging quits/hiring/job openings), today’s labor market shows decelerating nominal wage growth. In addition, the energy environment is totally different. The US is no longer an oil importer; we are mostly energy self-sufficient and have been since 2019.

The spike in energy prices has concerned many investors, but when looking at how energy prices impact core goods and services, the larger driver is labor. About 30% of the cost of goods at the retail level is labor; this makes labor roughly six times more powerful than energy as an input into final prices. We don’t see labor costs daily the way we see energy prices, but markets often fixate on the more visible (but less impactful) input. Diesel cost filtering through to freight and transportation we calculate to be roughly a 5% inflation impulse. So while annoying, the persistent energy cost increase moving through freight is a relatively small piece of the overall inflation equation compared to what labor costs could do if it moved higher.

Core Goods – Not Pointing to Inflation

Despite the largest tariff rate increase since the 1930s, core goods CPI has decelerated from 1.5% year-over-year to below 0.7%.

The bulk of the cost shocks can be (and have been) absorbed by exporters, importers, or profit margins without feeding through to consumers. While we’d love to see core goods inflation revert back to closer to 0%, this metric isn’t a high inflation driver.

Shelter Prices Decelerating

Home prices rose 1.6% in the year to June, below inflation of 3.5% and the 4.3% long-run average. New home prices are down 8.5% year-over-year, with 8.5 months of supply, and residential rents are falling due to an overbuilt multi-family market colliding with weak population growth (reduced immigration).

Plugging current housing data into the CPI in real time would push core inflation down closer to, or even below, target. While the Fed targets PCE, and shelter only makes up ~18% (vs. over 30% in CPI), plugging in real market data brings the index lower. And Warsh’s task force for data collection is considering revamping the data feeds to pull more timely market data.

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Potential Repeat of 2023 QRA Announcement?

The Treasury’s next quarterly refunding announcement is on Wednesday, November 4. The setup resembles November 2023, when Yellen’s surprised the market, managing the market fear of a long-end supply glut by shifting the bulk of issuance to the front of the curve.

Following her announcement, the 30-year yield fell from 5.075% to 4.99% within five minutes, and the rally extended into year-end; the 10-year fell from roughly 5% in October to below 4% by late December. Bessent can run a similar playbook. At the August 5 refunding, Treasury left its guidance unchanged for a second straight refunding, saying it expected to keep nominal coupon and floating-rate note sizes steady for at least the next several quarters. If Bessent again holds the line and leans on bills, we think long-end yields could rally as they did in 2023. Obviously, the risk is that a sudden signal for larger auctions could work the other way. The tradeoff is the heavy reliance on bills leaves the government more exposed to rollover risk, but only if rates stay high. If the Treasury expects policy rates may decline in 2027 (as we do), this could be part of a larger plan.

The Math of Bonds From Here

The chart below looks at the 1-year total return of a 10-year bond over 3 rate scenarios. Yields -100bps, yields flat, yields +100bps.

The total return of a bond is the income +/- the price fluctuation from interest rates. In a flat or down yield environment, the return from 10-year bonds is decently in the black. Additionally, buying a 10-year bond at today’s rates gives investors a large cushion via the income against price movement from rates.

Even if rates go up another 100bps, the 10-year bond would have roughly a -1.5% total return over the 1-year timeframe, a much different environment than faced going into 2022. In addition, the investor could reinvest the income at even higher rates. The other forgotten benefit of bonds is that, over time, they season as they get closer to maturity and return your principal, which also lessens the duration sensitivity.

Slowing Down Inflation Doesn’t Reduce Past Inflation – Let Bygones be Bygones

Past inflation has already occurred, and the Fed’s policy is not designed to correct for past sins. The only objective from here is to return the future trend of inflation back to the Fed’s target. We ran an analysis over the past ~30 years to show the cumulative “tax” of inflation and the long-term costs of “missing the mark” versus the Fed’s stated objective. The graphic above shows US CPI (white) is up ~109.6% through August 2026 from the Jan 1997 starting point (~2.5% annualized). The Pre-FAIT (flexible average inflation targeting) trend shown with the red dashed line signifies the 2% annual trend would have implied only ~79.7% cumulative gain by August 2026 had the pre-FAIT trajectory held. Obviously, this has not happened, and aiming for “average inflation” was a bad policy objective. Post the pivot from FAIT, the trend (orange dashed has run at 4.3% annualized. The gap between the two trend lines as of August 2026 is approximately 30 percentage points.

In Summary

The Fed hiked in September for the first time since 2023 and signaled just one more in the pipeline. The bond market now prices that path, and then some (about 3 hikes over the next 12 months), which have lifted 10-year yields to ~5.25%. We think that’s an overreaction.

Inflation is still above target, but the data doesn’t show it is getting worse. While this isn’t a call that we think rates are going to fall off a cliff, the market appears to be pricing in a rate-hiking cycle versus more of just a policy recalibration. We don’t see the fundamental drivers in place to warrant such a repricing in fixed income markets.

Disclosures

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The information contained herein should not be considered a recommendation to purchase or sell any particular security. Forward-looking statements cannot be guaranteed.

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