Fixed income: a hawkish Fed leaves the long end exposed

Washington’s two policy arms have started pulling in opposite directions, and the strain is showing up in the one place Australian portfolios feel it most, the long end of the US Treasury curve.

Treasury Secretary Scott Bessent wants lower US Treasury yields. He has moved to buy back more long-dated debt to get them.

Federal Reserve chair Kevin Warsh used his Jackson Hole keynote on 28 August to make plain that the central bank will no longer help. On 16 September the Federal Open Market Committee raised rates for the first time since July 2023.

Sonal Desai, chief investment officer at Franklin Templeton Fixed Income, argues that most of the commentary on the Treasury’s move has missed the point entirely.

“This generated a lot of commentary, most of which missed the mark, in my view,” Desai says. “Some have compared it to past Federal Reserve (FED) interventions, debating whether it was more similar to quantitative easing or to ‘operation twist,’ and suggesting that the Treasury is effectively taking over some of the Fed’s functions.”

Buybacks reshuffle the debt rather than reduce it

Bessent has said the Treasury will at least double the size of its buybacks of long-term debt over coming months, on the argument that long-term yields have detached from fundamentals and the intervention will restore proper market functioning.

Desai reads the mechanics differently. Buying back long bonds while the government still runs an outsized deficit simply changes which securities the market absorbs and leaves the total borrowing requirement untouched.

“This kind of Treasury intervention is irrelevant unless the fiscal deficit is reduced. As long as the government continues to run a deficit which is exceptionally large by peacetime standards, the Treasury needs to issue more and more debt.”

She points to spending pressure that keeps building rather than easing, including the cost of the conflict with Iran and tariff refunds, and expects a large deficit this year followed by a larger one in 2027.

A maturity wall built during the cheap years

The more awkward inheritance is the shape of the existing debt stock. Desai calls the debt management of the past decade remarkably poor, and the numbers support her.

Franklin Templeton Fixed Income research finds that 67 per cent of outstanding US government debt carries a maturity of less than five years. Some 54 per cent falls due inside three.

That was a choice. Through the years of near-zero rates after the global financial crisis and into the lockdowns, successive Treasury secretaries could have termed out the debt cheaply. They did not.

“We are now paying the consequences,” says Desai.

For an adviser, the practical consequence is a rolling refinancing task of enormous size that repeats every few years, at whatever rate the market demands on the day. Heavy front-end issuance keeps short yields anchored high, and every refinancing round tests appetite again.

Warsh draws a line between the Fed and the Treasury

Desai’s broader argument is that monetary policy has spent roughly 15 years accommodating fiscal policy. Warsh, she says, used Jackson Hole to end that arrangement.

Warsh declined to give markets the reaction function many analysts wanted. He argued that the Fed’s understanding of the economy is nowhere near precise enough. It cannot be reduced to a mechanical rule.

He was blunt elsewhere. He described 2 per cent on the personal consumption expenditure deflator as “a firm fixed target.” The central bank, he said, must deliver on it.

He said inflation, rather than employment, commands the Fed’s attention right now. The labour market sits close to full employment. Financial conditions remain relatively easy.

Warsh also made clear the Fed needs to act. It will do so unless underlying inflation moves towards the objective. That move must be clear and sufficiently fast.

Markets took the message at face value. The curve flattened, short-term yields ticked up, and Desai reads that bearish flattening as evidence investors have their eyes fixed on the fiscal side.

Desai read the speech as raising the stakes for what came next.

“It’s not forward guidance, but it does raise the stakes for the next Fed policy meetings. Unless the inflation picture improves significantly, it will be hard for the Fed to justify not raising rates,” she says.

The Committee acted three weeks later. The target range moved 25 basis points higher to 3.75 to 4.00 per cent on 16 September on a unanimous vote, and Warsh returned to the symposium in his press conference remarks.

“As I said at the policy symposium in Jackson Hole, I would be hard-pressed to describe broad financial conditions as restrictive,” Warsh says.

The projections released alongside that decision put sixteen of eighteen participants behind at least one further increase by year-end, which leaves the policy rate heading higher into the same window the Treasury needs to refinance.

Where the Fed and Treasury read the same signals differently

Desai draws out one exchange that puts the two arms in direct opposition. Among the unfiltered signals Warsh wants from financial markets, he named the prices and trading volumes of Treasury securities. That is the same market Bessent has described as detached from fundamentals. One official reads those prices as information, the other reads them as a malfunction.

Warsh also revived a phrase with teeth. He said “money matters”, which Desai treats as a pointed signal that he wants the Fed’s balance sheet smaller and its holdings of government debt reduced.

A central bank shrinking its Treasury book while the Treasury issues more of them removes a buyer the market has relied on since 2009.

Where the argument could break

The thesis has an obvious failure mode, and advisers should hold it in mind. Higher-for-longer calls built on deficit projections have repeatedly come undone when growth data turns.

A genuine labour market crack would push the Fed towards cuts and drag long yields down regardless of the borrowing schedule, as it did through several false starts since 2022. Warsh’s hawkishness also remains untested by a recession, and Jackson Hole speeches bend when unemployment rises.

There is a second consideration closer to home. Australian advisers holding hedged global bond exposure earn the hedge return from the interest rate differential. A US curve that stays steep at the front changes the economics of that hedge as much as the underlying yield does.

The portfolio question for advisers

Duration has spent two decades earning its place as the equity hedge. That role depends on US Treasury yields falling when growth disappoints. A market pricing fiscal risk into the long end will not always oblige.

Advisers running balanced portfolios should ask whether their defensive sleeve still behaves defensively under a fiscal shock rather than a growth shock. Those two scenarios move bonds in opposite directions.

Desai’s own conclusion points at Washington rather than the bond market.

“If the government wants to reduce the cost of its debt, it will have to take a hard look at its own fundamentals and bring the fiscal deficit down to more sustainable levels,” she says.

“Until then, elevated government borrowing requirements combined with growing debt issuance to finance AI investment are likely to maintain persistent upward pressure on yields.”

That last clause deserves attention. The capital expenditure wave funding data centres is increasingly financed in the same bond market that funds the deficit, and both sets of borrowers want the same buyers.

Advisers reviewing fixed income allocations are pricing that competition whether they have named it or not.