Key Highlights

• Powell admits the Fed is in “a difficult situation” with both of its objectives at risk.
• Uncertainty dominates, with little point in offering forward guidance while in the fog of war.
• Additional bill issuance is likely – watch the TGA for signs of resulting liquidity stress.

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FOMC recap: “We just don’t know”

EXHIBIT #1:  SWIFT REPRICING OF FED EXPECTATIONS

_{Source: BNY Markets, Bloomberg} 

The March FOMC met our expectations, with no rate changes, no major changes to the Summary of Economic Projections, and little – if any – forward guidance to the future path for policy rates. None of this surprises us, although markets were quick to price in a more hawkish path for rates thereafter. This, too, shouldn’t be terribly surprising given the increase in inflation expectations due to higher energy (and other industrial materials prices) costs and a Fed that is clearly on hold for now.

On February 27, the day before the start of the Middle East conflict, implied expectations from the OIS curve indicated around 60bp in cuts by December this year. As of this writing, just before the Monday open in the U.S., the market now sees nearly 18bp of tightening, essentially moving from two cuts to nearly a full hike by year end. Exhibit #1 shows this dramatic repricing between February 27 and March 19, the day after the FOMC met. We also show how much the curve moved in the two trading sessions between the meeting and this Monday.

While this repricing is understandable, we think the rate path is far from set in stone. The duration of the war and the increase in energy and other industrial materials prices are major unknowns. Just this morning, word of a U.S. standdown has moved markets for now. Indeed, one could entertain a scenario in which the war concludes in a timely manner and input prices begin to decline (although we don’t think they’ll return to pre-conflict levels this year) easing inflation expectations – yet the growth shock pushes an already moribund labor market into contraction. In such an environment, cuts could be back on the agenda for H2 2026, as the inflation shadow begins to move in a satisfactory direction while demand remains under pressure. A more prolonged conflict would mean elevated inflation expectations, preventing the Fed from cutting.

As Chair Jerome Powell repeated three times in his press conference: “we just don’t know.” Earlier last Wednesday, at the Bank of Canada’s rate-setting meeting, Governor Tiff Macklem declared that “uncertainty is acute.” This shared sentiment by central bankers is hardly unexpected and is, for us, an accurate if potentially unsatisfying assessment. Furthermore, the usual practice of assigning probabilities to each of the many paths the conflict could follow is an especially fraught exercise in the fog of war, particularly this one. Monday morning’s events are an apt demonstration of this.

EXHIBIT #2: YIELD MOVE HIGHER MAINLY DUE TO RISING INFLATION CONCERNS

_{Source: BNY Markets, Bloomberg}

In the short term, however, the market bet is for no cuts, and maybe even a bias to tighten. It’s useful to consider a simple decomposition of the 10y benchmark yield as the sum of real rates (TIPS) and inflation expectations (breakevens), as we show in Exhibit #2. Of the 45bp increase from 3.94% on February 27 to 4.39% at the end of Monday’s APAC session, fully 32bp were from higher breakevens, while another 13bp can be attributed to real rates. We interpret the move in real rates as an increase in policy rate expectations. Not coincidentally, this almost matches the 18bp increase in rates implied in the December 2026 OIS contract. We do not observe any meaningful increase in the term premium, so we wouldn’t describe fiscal concerns as a key driver – yet.

Considerations of the conflict’s impact on funding markets

EXHIBIT #3: ISSUANCE AND TGA DIRECTIONALLY LINKED

_{Source: BNY Markets, U.S. Treasury Department}

Some back-of-the-envelope arithmetic suggests about $125bn per year in foregone tariff revenues due to the Supreme Court’s decision last month, although it remains unclear how much of those revenues could be replaced with other (non-IEEPA) measures. If we simply assume a round number of $100bn in missing tariff revenue, and the administration proceeds with a supplemental defense request equal to the rumored $200bn, we expect most of this sum to be issued in bills, especially with coupon yields rising so rapidly at present.

In the past we have estimated that the Fed could be purchasing as much as $400bn in bills this calendar year: $40bn per month in RMPs through April (total = $160bn), then $20bn per month thereafter (total = $160bn), and another approximately $10bn per month in reinvested ABS proceeds (roughly $100bn total). That would more than absorb any new issuance discussed above, but would leave the rest of the market to absorb the already-promised bill supply from the last quarterly funding announcement.

The Treasury General Account (TGA) is currently flush at around $900bn after fluctuating between $800bn and $1tn since September 2025. Issuance typically drives the TGA higher, as seen in Exhibit #3, which plots the three-month moving average of TGA increases against the same for net bill supply. The relationship is clear and intuitive.

The question thus naturally arises: will several hundred billion in additional bill supply cause TGA to swell, putting pressure on reserves and ultimately financing rates, despite our forecast of additional Fed purchases? This could be an issue to confront once Washington begins to formally address any supplemental funding needs for the war.

Rates outlook

We fleshed out our logic on rates above and believe that some de-escalation – perhaps even a cessation of hostilities – within a reasonable timeframe will allow the Fed to enact two cuts. We remind readers that until last week, we were still in the three-cut camp, but given the big move in inflation expectations, we think there might not be enough room left in the H2 FOMC calendar for more than two cuts – likely in the final few months of the year, probably the October and December meetings. If things cool down even sooner, and the possible labor market stress we see does reveal itself, a September cut after Jackson Hole remains possible.

We feel at a loss to assign meaningful, high-conviction probabilities to any plausible scenario. However, another scenario would be for inflation to remain elevated or rise further, taking inflation expectations with it. In that scenario, with no changes in rates, the real policy rate, net of inflation, would actually be falling, preventing the Fed from cutting the nominal rate for the remainder of the year. These are admittedly bimodal potential outcomes, and we favor the eventual easing scenario. With both Fed goals at risk, as Chair Powell put it, the central bank is “in a difficult situation.”

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