Warsh Nomination and the Steepening Curve: A Structural Shift in U.S. Yield Expectations

The immediate catalyst for recent Treasury market moves is clear. President Trump's nomination of Kevin Warsh as Federal Reserve Chair last Friday has prompted a swift recalibration of policy expectations. Markets view Warsh as a more hawkish figure, particularly on the critical issue of the Fed's balance sheet. His past criticism of the central bank's asset purchase programs signals a potential unwillingness to maintain a large, liquidity-providing balance sheet, a shift that could reduce financial system liquidity over time.

This specific nomination has directly driven a steepening of the Treasury curve. Last week, the move was quantified: 2-year yields fell -7 basis points (bps) while 10-year yields rose 1 bp and 30-year yields rose 5 bps. The mechanism is straightforward. The market is pricing in a Fed under Warsh that will likely be less aggressive in cutting rates than some alternatives, yet still committed to a gradual easing path. The steepening reflects a shift in expectations for long-term yields, as investors anticipate a more restrictive stance on balance sheet normalization.

Yet a central tension remains. Even as the curve steepens on this hawkish tilt, markets continue to price in two Fed rate cuts this year under Warsh. This creates a divided outlook within the FOMC itself, where policymakers are split on the pace and scale of further easing. The question now is whether this steepening is merely a transient reaction to the nomination news or the start of a new structural trend. The divergence between the market's rate cut pricing and its long-end yield moves suggests uncertainty about the ultimate trajectory of policy, making the coming months a critical test of whether the hawkish balance sheet narrative will ultimately outweigh the dovish rate-cut expectations.

Quantifying the Shift: The Magnitude and Mechanics of Steepening

The recent shift in the Treasury market is now quantifiable. As of Monday, the yield on the benchmark 10-year Treasury note stood at 4.22%, while the 2-year note yielded 3.578%. This creates a spread of approximately 64 basis points between the two key maturities. The move last week was a clear signal of the curve steepening, with 2-year yields falling -7 basis points (bps) while 10-year yields rose 1 bp and 30-year yields rose 5 bps.

This divergence is the mechanical heart of the current market dynamic. Near-term rates are being anchored by the Federal Reserve's steady policy. The central bank has held its key rate steady, and Chair Powell's recent comments leaned slightly hawkish, providing a floor for short-term yields. The pressure is coming from the long end, where expectations for a more hawkish balance sheet normalization under a Warsh-led Fed are pushing yields higher. The market is pricing in a Fed that may be less aggressive in cutting rates, but the real catalyst for the steepening is the perceived threat to the Fed's massive liquidity-providing balance sheet.

The result is a market caught between two narratives. The near-term anchor is the Fed's current policy stance, while the long-term trajectory is being reshaped by expectations of a more restrictive balance sheet. This tension is what has driven the curve to steepen, as investors adjust their views on the ultimate path of financial system liquidity. The magnitude of the move-particularly the rise in the 30-year yield-suggests that the hawkish balance sheet narrative is gaining significant traction in the pricing of long-term risk.

Financial Market Implications and Sector Rotation

The steepening Treasury curve is not just a yield curve story; it is a powerful engine for sector rotation across fixed income. As the market re-prices long-term risk, capital is flowing toward assets that offer better yield or risk-adjusted returns, while others face pressure from supply and shifting sentiment.

The divergence in weekly performance is stark. Investment grade corporates returned -0.11%, lagging similar-duration Treasuries by 9 basis points. High yield corporates weakened further, returning -0.16% and underperforming by a full 33 bps. This retreat occurred despite robust demand, with the asset class seeing $11 billion in inflows. The pressure is technical: supply remains heavy, with January's issuance above $200 billion, 18% ahead of last year's pace. The market is effectively saying that the yield pickup from these spreads is insufficient to compensate for the added credit risk and supply headwinds in this new regime.

In contrast, municipal bonds held steady, with yields essentially unchanged. This resilience is driven by strong demand and reinvestment flows, which have been outsized. Record reinvestment dollars are arriving, and fund inflows remain robust. The sector's appeal is multifaceted: it offers tax advantages, and with light new issue supply, it is well-positioned to absorb these flows. The market is rotating into munis as a stable, high-quality alternative that benefits from structural demand.

Emerging markets provided the standout relative performance, returning 0.09% and beating similar-duration Treasuries by 6 bps. This outperformance is a classic search-for-yield move. With U.S. long-end yields rising, investors are looking further afield for income. The sector saw accelerating inflows of $3.5 billion, supported by light supply and solid demand. It is a clear signal that capital is seeking yield where it can be found, even at the cost of added currency and geopolitical risk.

The bottom line is a market in active rebalancing. The steepening curve, driven by hawkish balance sheet expectations, is forcing a reassessment of value. Investors are moving away from sectors facing heavy supply and tightening credit spreads, while rotating toward assets with strong fundamental demand or superior yield profiles. This rotation is the practical manifestation of the new yield expectations being priced into the Treasury market.

Forward-Looking Implications and Key Watchpoints

The current thesis of a structural steepening faces its first major test in the coming days. The immediate catalyst is the House's potential approval of the spending deal. This agreement, which has already been reached by leaders, would reduce near-term fiscal uncertainty and could provide a temporary floor for longer-term yields. If passed, it would remove a source of volatility that has contributed to the recent risk-off mood and the 10-year's decline to 4.22%. The market's reaction to this vote will be a key early signal of whether the steepening trend can persist once this specific overhang lifts.

The primary risk to the thesis, however, lies in the market's own pricing. Despite the hawkish tilt on balance sheets, markets continue to price in two Fed rate cuts this year under Warsh. This creates a fundamental tension. If Warsh's hawkish stance leads to a slower pace of easing than currently anticipated, the market's rate cut forecast could prove overly optimistic. A failure to materialize those cuts would likely force a reassessment of the entire policy outlook, potentially reversing the long-end yield moves that have driven the steepening.

For investors, the path forward is clear. The key technical levels to watch are the 10-year Treasury yield and the 2s/10s spread. The 10-year's recent dip to 4.22% is a critical technical level; a break above it would confirm the long-end yield pressure is gaining momentum. More broadly, the 2s/10s spread is the direct measure of the curve's steepening. A sustained widening would validate the shift in expectations for long-term risk and liquidity.

The coming weeks will separate signal from noise. The House vote is the first hurdle. Then, the focus shifts to Fed communications and economic data, which will test the durability of the hawkish balance sheet narrative against the entrenched expectation of future rate cuts. The market is in a recalibration phase, and these events will determine whether the recent steepening is a fleeting reaction or the start of a new structural trend.