Surging Treasury yields pose a brand new problem for Kevin Warsh and the Fed

The bond market is yelling at the Federal Reserve, but the messages are coming from different directions and pose a dilemma for policymakers as they seek to strike a balance that won't tank the economy.

Treasury yields continued their upward march Thursday as investors sought to price in a variety of factors: inflation still hovering well above the Fed's 2% goal, another bump up in energy prices and the impact of a global hyperscaler financial arms race and accompanying debt issuance.

In the past, policymakers have been willing to look through inflation spurts from temporary shocks like high energy prices and tariffs. And the narrative not so long ago was that the artificial intelligence investing boom was a story that would last a year or two and ultimately prove disinflationary.

But now Fed officials are rethinking the impact of those factors and seeing the danger of more durable inflation.

At the same time, markets are grappling with a central bank that suddenly has no interest in telegraphing its next moves, leaving an uncertain calculus on who is calling the shots — policymakers or market players.

"The time of looking through the initial supply shock has come to an end," said Joseph Brusuelas, chief economist at RSM. "The bias has to be towards restoring price stability, and they should take what's going on seriously."

Over the past day or so, traders raised the odds of a rate hike in October, which would come only a month or so after last week's quarter percentage point increase. They also see a third increase either late this year or early in 2027, with additional hikes possible in subsequent months.

That's a big switch from a Fed that in June projected it might hike once this year and then be done before starting to cut in the next couple of years.

"My view coming out of the [September] meeting was that we're going to get three rate hikes," Brusuelas said. But modeling performed at his firm about the potential for higher yields, along with a prolonged cycle of AI investment, changed that view.

The modeling indicated that sharply higher long-term yields could slow growth and increase unemployment and still not get inflation back to 2%. RSM found that even a 5.5% 10-year yield — it was around 5.15% on Thursday — would lower growth to 1.5% and lift unemployment to 4.7% while core inflation remained stuck at 2.4%.

"The Fed is underestimating what's going to be necessary to restore price stability — that we're probably not talking two or three hikes. We're talking five or six," Brusuelas said.

Not everyone on Wall Street agrees. Some strategists think the market is getting ahead of itself — that yields now essentially are pricing in stronger economic growth and are overly sensitive to the vagaries of oil prices amid the ongoing tensions in the Middle East.