The Federal Open Market Committee left the federal funds rate unchanged at its July meeting, delivering the hawkish hold that markets had largely anticipated. However, the market reaction implies the story is more nuanced than the headlines suggest.

The Fed Decision

While the vote was more hawkish than expected, with three of the nine committee members preferring a rate increase, the accompanying message struck a more dovish tone, emphasizing the need to be “especially prudent at these uncertain times” with Chairman Warsh reiterating there is “no tolerance” for inflation running above target.

The caution likely reflects an acknowledgment of current constraints.  Monetary policy is not effective against the current sources of inflation; an oil supply shock compounded by supply chain disruption and potential tariff-induced pressures.

Conversely, the Q2 real GDP advanced estimate eased to 1.5% from 2.1% in Q1, with the potential that growth has been flattered by tax rebates and the World Cup. As these impulses fade, raising rates risks demand destruction, heading into a potential second-half slowdown, for only a modest and uncertain near-term benefit. That is an unattractive trade-off, and the Committee appears to recognize it.

The Market Response

The market’s response was telling. The yield curve steepened, with longer-term rates rising even as shorter-term rates fell, while futures-implied odds of a September hike declined.

In effect, bond markets are not pricing in the moderating inflation path with subdued wage pressure, a limited rebound in oil prices or easing shelter costs.

That raises the question: Why price in higher inflation when the Fed decision was expected and Fed policy is largely ineffective against supply-induced price pressures? A few possible explanations include:

• The more dovish commentary risks higher inflation expectations, which in turn become self-fulfilling. Yet Fed research suggests this belief rests on “extremely shaky” theoretical and empirical foundations.[1]
• Despite Chair Warsh’s credentials as an inflation hawk, market participants may be interpreting the decision as evidence of political pressure and a loss of Fed independence.
• Higher long-term rates may simply reflect an additional risk premium demanded in exchange for reduced forward guidance.

TwinFocus Conclusion:  Whatever the precise reason, current market conditions suggest the balance of risk to long-term rates remains skewed to the upside.

The Rate Picture

On balance, the path for short-term rates appears lower while the path for long-term rates appears higher due to a confluence of forces.

• The potential for persistent inflationary pressure driven by on-going energy uncertainty and the risk supply chain disruptions translate into broader inflation with Fed policy largely ineffective against supply-driven price shocks.
• Potentially higher import prices with the announcement of tariffs ranging from 10-12.5% on ~60 trading partners on claims they failed to properly stop forced labor, though potentially a work around after the Supreme Court ruled tariffs imposed under emergency powers were illegal.
• Elevated policy uncertainty as the Fed moves away from providing forward guidance and seeks to make decisions without managing market expectations. The reduced ability to predict monetary policy may result in an additional term premium.
• At the same time, slower growth, potentially recessionary, looms as capital is redirected from consumers and other productive uses to AI capex, potentially translating into weaker consumer spending.
• The federal deficit is likely to widen further, with the administration requesting additional appropriations to fund defense spending and the cost of the Iran conflict, adding to the supply of long-dated government debt.
• While the Fed will seek to maintain its perception of independence, pressure to cut rates will intensify as the 2026 midterm elections approach, potentially creating a political undertow that pulls in the opposite direction from where inflation points.

Prudent to Prepare for High(er) Rates

As we wrote in January  Run It Hot, Except Bitcoin:

Most wealth models are built on the recency bias of the last three decades, where generally in risk-off environments equities fell, but bonds prices rose in response to lower yields. Our suspicion is that it is less true today, and that stocks and bonds are becoming more correlated in risk-off environments as the next crisis comes from an inflationary shock, not from a deflationary one. [Emphasis Added].

While we are not predicting an inflationary (or deflationary) shock, traditional 60/40 portfolio construction benefits from lower rates while being adversely exposed to higher rates. If the next dislocation is inflationary, or the curve continues to steepen, duration is not a hedge, it is an exposure.

While higher rates have restored opportunity in income-oriented assets, we believe investors must be selective about where they assume duration, credit, and liquidity risk.

Accordingly, we recommend diversifying long duration fixed income exposures:

• Within public market fixed income exposure, favor high quality and short duration.
• Within private market exposure, focus on capital-constrained idiosyncratic credit strategies offering uncorrelated return streams, while avoiding private credit BDCs.
• Increase exposure toward gold and global commodities, which are expected to provide a meaningful buffer if inflation remains persistently above the current 3% base case with limited risk to relative returns if it does not.

More broadly, we believe decades of global underinvestment in commodities is finally coming to a head. The asset class has lain dormant for the last two decades but is trending higher. Historically, such breakouts from multi-decade bases have signaled larger structural moves.

[1] Rudd, Jeremy (2021), “Why Do We Think That Inflation Expectations Matter for Inflation?” Federal Reserve Board Working Paper

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