What happens next at the Fed matters
If the S&P 500 is the dog that wags the global stock markets’ collective tail, then the U.S. central bank – The Federal Reserve – is the brain controlling that dog. What happens at the Fed matters to almost every investor around the world.
And those investors have grown accustomed to dancing with a Federal Reserve that provided reams of forward guidance, as well as a dependable feedback loop. When the Fed spoke, markets adjusted, and increasingly innovative monetary policy smoothed over any volatility.
However, under Kevin Warsh – Trump’s newly anointed Fed chair – the playbook investors have grown comfortable with is being rewritten.
Warsh has assumed the Fed Chairmanship amid a period of stubborn inflation, rising bond yields, and an escalating conflict with Iran. That’s not necessarily materially different to the uncertain backgrounds inherited by previous Fed chairs, but what is different is today the central bank also faces a structural dilemma. Warsh inherits an institution trapped between a US$2 trillion annual fiscal deficit and an international backdrop where traditional buyers of U.S. debt are pulling back – something we have written about here many times.
With that context in mind, it seems reasonable for investors and the broader U.S. economy to assume what happens next at the Fed will be defined less by short-term rate tweaks and more by whether the central bank can resolve its intractable dilemma.
The death of forward guidance and internal friction
Under Warsh, the Fed’s operational posture is undergoing something of a renovation. Warsh has expressed a desire to curtail explicit forward guidance and has encouraged the market to stop hanging on every central bank utterance. Meanwhile, internally, Warsh has established a special internal task force to challenge long-standing institutional groupthink.
But it’s the shift away from explicit guidance that’s created an information vacuum. And despite market-based inflation measures remaining relatively subdued, core Gross Domestic Product (GDP) deflators running above 3 per cent and short-term benchmark yields indicate the market is pricing in rate hikes.
Unsurprisingly, without a clear public outline of the new leadership’s “reaction function,” volatility is surfacing within the Fed itself. Public commentary and dissenting votes – such as those from Governor Christopher Waller – reveal internal alignment is far from guaranteed. While Warsh seeks to restore price stability and allow free-market supply and demand to price capital, the transition away from a heavily managed policy signal is creating friction inside and outside the Federal Open Market Committee (FOMC).
The international backlash and foreign treasury liquidations
Compounding Warsh’s internal challenge is the shifting global landscape alluded to earlier. Historically, during periods of global stress, international capital flowed seamlessly into U.S. Treasuries. Today, major foreign holders are scaling back net purchases or actively reallocating reserves. China continues to trim its exposure, and as the war with Iran drives global energy prices higher, Japanese oil importers are forced to purchase U.S. dollars at record rates to fund inflated fuel bills, widening that country’s trade deficit and driving the yen down.
This, in turn, has forced Japan and the U.S. towards coordinated currency intervention as rising Japanese rates threaten to unwind the yen carry trade – where investors borrow money in Japanese yen at very low interest rates and sell it to buy higher-yielding foreign assets or currencies, pocketing the difference. The yen carry trade is a major source of global liquidity that has helped support risk assets and U.S. technology valuations. An unwind would be felt across asset classes globally – especially those that have relied on cheap funding to fuel stretched valuations.
It’s important to understand when foreign central banks are forced to defend their currencies, they either have to sell U.S. Treasuries for cash or seek liquidity facilities. To avert involuntary dumping of Treasuries that would send U.S. borrowing rates surging, the U.S. Treasury and the Fed have employed the Foreign and International Monetary Authorities (FIMA) repo facility.
By allowing foreign entities to post Treasuries as collateral in exchange for U.S. dollars, officials hope to stabilise the yen-dollar dynamic and prevent secondary market dumping. However, this strategy highlights a growing vulnerability: central banks around the world are diversifying their balance sheets into alternative reserve – most notably gold.
The US$2 trillion deficit
While energy price shocks and international currency dynamics are complications for the Fed, the primary obstacle facing monetary policy is fiscal: a U.S. national debt expanding by roughly US$2 trillion annually.
This deficit puts the Fed in an extraordinary bind because if it tightens rates aggressively to stamp out persistent inflation, it drives up interest expenditures on the national debt, increasing the federal interest burden and squeezing private sector investment. But if the Fed maintains lower rates or expands its balance sheet to accommodate Treasury issuance, it risks monetising the debt and cementing long-term inflation.
Former Fed officials and economic analysts refer to this as the “impossible problem.” The Fed can’t single-handedly offset unchecked fiscal expansion without imposing real costs on the economy. High borrowing rates aimed at cooling inflation disproportionately penalise private enterprise while doing little to curb mandatory government spending, which must fund its debt at prevailing auction rates regardless of cost.
Implications for markets and the economy
There are at least three possible implications for investors in 2026 and beyond.
The first is that without explicit forward guidance, Treasury yields will react more aggressively to individual data prints. The long end of the yield curve, in particular, will increasingly reflect fiscal debt supply rather than just Fed policy rate expectations. And that means generally higher bond rates, which are a negative force on equity valuations.
Meanwhile, persistent government debt issuance risks crowding out corporate borrowers. As yields remain elevated to attract capital, the cost of capital across real estate, private credit, and corporate investment will stay higher for longer. That’s a negative for the economy.
Finally, the tension between the Fed attempting to shrink its balance sheet and the Treasury needing to auction unprecedented amounts of debt creates friction that could feed ongoing volatility.
Many now believe the era of cheap capital and predictable central bank signalling has ended. The Fed is attempting to return to the core principles of price stability and market-driven interest rates, but it’s doing so amid historic fiscal deficits and shifting international priorities and alliances.
What does it all mean for equity investors? One must look past Fed commentary and pay closer attention to the structural pillars of global debt supply, liquidity, inflation, and fiscal policy.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
He is also author of best-selling investment guide-book for the stock market, Value.able – how to value the best stocks and buy them for less than they are worth.
Roger appears regularly on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
