The Federal Reserve's determination to fight inflation shown last week gave investors reason to be optimistic about the market, and risk assets did not experience sustained selling. However, what is making them hesitate is that new Fed Chairman Warsh has not clearly stated how far this tightening cycle ultimately needs to go.

Last week's policy meeting also reaffirmed the Fed's policy credibility to a certain extent. Previously, investors were concerned about whether the Fed would be willing to endure market pressure from higher financing costs while inflation remained above target. The rate hike and more hawkish stance at least answered that question, but there are still no clear answers regarding the terminal rate, the pace of hikes, and whether energy prices could force further policy tightening.

5% Treasury Yield Fails to Reproduce the 2023 Panic

Currently, the market's capacity to tolerate high interest rates is shifting. The 10-year Treasury yield broke above 5% last week, again touching highs not seen since 2023, but compared with October 2023 when yields approached 5%, this bond market rout has not produced the same level of volatility. The annualized volatility implied by three-month options on the 10-year Treasury yield is approximately 79.5 basis points, compared with approximately 134 basis points in the same period of 2023.

The difference lies in the fact that this yield increase has gone through a longer repricing process. At the beginning of the year, investors were still discussing rate cuts; now the market has shifted toward accepting multiple hikes and a higher long-term policy rate. Barclays derivatives strategy head Amrut Nashikkar believes that the current decline in Treasuries reflects a stronger-than-expected U.S. economy rather than a sudden market concern about a malfunction in Treasury demand.

Bloomberg believes the Fed meeting was therefore closer to a market "clearing" event. Before the meeting, investors had already reduced risk exposure and increased hedging, and last Friday's massive quarterly options expiration further reset positions. Societe Generale strategist Manish Kabra noted that corporate earnings growth remains strong, credit spreads are under control, and the VIX index remains at low levels, meaning the fundamental support for U.S. stocks has not disappeared.

Interest rate options data also show that the market is currently not pricing in a large-scale disorder in the long-term rate system. Investors' increased hedging is concentrated in short-term rates, because there is still high uncertainty around the next few Fed meetings, while the rise in long-term term premiums has been relatively limited.

Market Accepts the Hawkish Direction but Struggles to Judge the Terminal Rate

The direction given by the Fed is already quite clear: until inflation returns to target, there is still room for further policy tightening. The problem lies in the magnitude and timing of the hikes. Fed Chairman Warsh described the hike as removing a "dose of accommodation" from the economy. This statement has drawn significant attention on Wall Street because it implies the Fed may still believe the current financial environment has some stimulative effect.

Warsh also downplayed the importance of the traditional "neutral rate" framework. When asked where the 3.75%-4% policy rate stands relative to the neutral rate, he said the neutral rate is useful in academic discussions but does not directly determine current policy operations. This leaves investors without a policy benchmark they have often used in the past.

The Fed's dot plot shows that most officials currently only clearly expect at least one more hike this year, but the swaps market has already priced in three more hikes by the end of July next year. This discrepancy does not necessarily mean the market believes the Fed's forecasts are invalid. Warsh himself is reducing forward guidance on the future rate path, and has twice failed to submit personal dot plot projections.

Policy is becoming increasingly dependent on subsequent inflation, growth, and financial condition changes, so investors can only re-estimate the Fed's reaction at each meeting. The result is that high interest rates themselves are gradually becoming a calculable variable, while the policy path is more prone to creating volatility. Barclays' Nashikkar said that without forward guidance, higher short-end rate volatility surrounding each meeting is likely to become a structural feature of the market.

Oil and AI Determine Whether the Market Can Continue to Digest High Rates

Bloomberg believes that two variables are currently preventing investors from fully increasing risk exposure: energy and artificial intelligence. Energy prices first determine how hawkish the Fed needs to be. On Monday, Brent crude remained near $100, and refined products like diesel continued to be elevated, increasing the risk of a renewed rise in inflation. Barclays strategist Emmanuel Cau's team believes that until energy-driven inflationary pressures clearly decline, both rates and equity markets will struggle to fully stabilize.

On the positive side, the Fed has made investors more aware of how policy will respond when inflation rises again. The other variable comes from the AI cycle that has supported U.S. stock valuations and economic investment over the past few years. Currently, the market has begun to scrutinize AI capital expenditures and the returns they can generate more strictly. Within the technology sector, there has also been a clear divergence: software stocks have regained strength, while the semiconductor sector has been stagnant overall over the past two months with rising volatility.

The valuation of the S&P 500 has already dropped significantly and is now only slightly above its long-term average. Part of the valuation decline comes from rapidly rising earnings expectations, but it also reflects that investors are no longer willing to unconditionally pay higher prices for long-term growth. If AI investments ultimately fail to deliver the returns currently implied in earnings forecasts, valuation constraints will become more pronounced in a high-rate environment.

The Treasury market is also showing this delicate balance. The Wall Street Journal noted that this year the 10-year Treasury yield has risen from approximately 4.17% to above 5%, but long-term inflation expectations have risen only modestly, with most of the change coming from real rates. Short-end yields have risen significantly more than longer maturities, indicating that the market mainly interprets this adjustment as economic resilience and Fed hike expectations rather than a complete de-anchoring of long-term inflation expectations.

As long as economic growth and corporate earnings remain resilient, and credit markets do not deteriorate significantly, a 10-year Treasury yield around 5% does not necessarily trigger sustained declines in risk assets. The market can more easily price a higher but relatively clear rate center. What makes trading more difficult now is the possibility that energy prices could once again change the inflation trajectory, along with a Fed hiking path that lacks a clear endpoint.