Weekly signals: The “why” behind the rate environment

Kevin Warsh was confirmed as the 17th Federal Reserve Chair on May 13 in a largely partisan vote. He takes office having called for "regime change" at the Fed—less forward guidance, fewer press conferences, and a new inflation framework. He also inherits CPI at 3.8%, PPI running at its hottest pace since December 2022, and a committee whose composition he does not fully control. The environment is complex, and the range of plausible policy outcomes is wider than markets currently reflect.

Three constraints shaping the June meeting:

1. Inflation limits near-term flexibility.
   Fed funds futures are pricing in a roughly 46.5% probability of a rate hike by the end of 2026. Several FOMC voting members have signaled concern about broadening inflation; Boston Fed President Collins has raised the possibility of rate increases if conditions warrant. Warsh has welcomed open debate within the committee—and that debate appears likely to lean hawkish in the near term.
2. The chair has one vote.
   The FOMC currently includes three Trump-era appointees, three Biden-era governors, and former Chair Powell, who has elected to remain on the Board of Governors through 2028. Rate decisions reflect the full committee, and Warsh will need to build consensus rather than act unilaterally.
3. Less guidance means more uncertainty.
   Warsh's stated preference for reduced forward guidance and fewer communications creates a policy information gap at precisely the moment markets are seeking clarity—a shift is not yet reflected in the pricing of rate volatility.

The more important question: Why are rates where they are? 

The conversation around interest rates tends to focus on direction and level. Historically, however, outcomes have been driven less by how rates go, and more by why they are rising.

Rates driven by strong GDP growth, capital investment, and earnings reflect demand for capital. By contrast, rates rising due to supply shocks or entrenched inflation signal tighter financial conditions.

The two environments have produced very different outcomes for risk assets.

What history says about high real rates

Across nearly nine decades, both equities and bonds have delivered their strongest risk-adjusted returns when real rates were in their highest historical quartile.

Exhibit 1: Risk-adjusted returns of stocks and bonds, 1935 to present

S&P 500 and the U.S. Long-Term Treasury Composite Yield in Quartiles of Real Rates

Why? High real rates have historically coincided with strong nominal growth environments, where corporate earnings power and pricing offsetting the impact of higher discount rates.

What’s happening in the current economic environment? It reflects both dynamics. The geopolitical energy shock is indeed a supply-side pressure. But underlying economic drivers—capital spending, corporate earnings, employment and credit—underpin an expansion that’s still in progress.

Where we are in the business cycle

Beyond the rates debate, the business cycle remains the most important driver of intermediate-term portfolio outcomes—and the current positioning looks constructive.

Global business cycle in an unsynchronized expansion

The global economy remains in a solid expansion amid policy crosscurrents

The U.S. is firmly mid-cycle: credit growth looks solid, profit growth is near its peak, policy is close to neutral, and inventories and sales are in equilibrium. Mid-cycle expansions have historically been the most durable phase for risk assets, characterized by broadening earnings growth rather than the credit tightening and margin pressure that define late-cycle deterioration.

The global picture adds context. China is early-cycle, with momentum still building. Japan, the Eurozone, and Canada are transitioning from early- to mid-cycle. The demand impulse from non-U.S. economies is still developing—a modest but meaningful positive for globally diversified portfolios and U.S. companies with international exposure.

KEY TAKEAWAYS

1. Rate volatility appears underpriced.
   A new, less communicative Fed chair navigating a supply-shock environment introduces policy uncertainty that’s not reflected in the MOVE Index (bond market volatility). Strategies that benefit from elevated rate volatility—specifically active products—stand to benefit.
2.  The “why” behind rates is constructive.
   Historically, strong capital investment and mid-cycle growth have helped risk-adjusted returns, even in elevated rate environments. Supply-driven energy shocks have not historically forced aggressive Fed tightening. For equity investors, quality and cash flow visibility remain foundational, and selective exposure to secular growth themes—such as AI infrastructure and re-shoring—are supported by the current capital investment cycle.