Citadel Securities has indicated that Federal Reserve Chair Warsh's commitment to lowering inflation could help bolster the central bank's credibility, thereby supporting long-term U.S. Treasury yields and compressing term premiums.

Nohshad Shah, the firm's Head of Fixed Income Sales for Europe, the Middle East, and Africa, noted that trading in the U.S. Treasury market since the Fed meeting last week has been characterized by greater stability in long-term yields relative to two-year notes. A highly credible Fed should be beneficial for long-term rates.

Since last week's meeting, the yield curve has flattened, with long bonds outperforming the short end. The spread between two-year and 10-year Treasury yields has narrowed from about 40 basis points before the meeting to 27 basis points. The spread between two-year and 30-year yields has also contracted from approximately 90 basis points to around 71 basis points.

Some market participants believe a shift in the Fed's communication style could lead to greater interest rate volatility and prompt bond investors to demand higher term premiums.

Shah suggests this view may be mistaken. He stated that if the Fed can act swiftly and decisively based on economic data, it would actually enhance its credibility. This implies the market needs to adapt to a Fed that will not wait for rate hikes or cuts to be fully priced in before moving.

Shah believes that in this context, the yield on the 10-year Treasury note, which is crucial for U.S. mortgage and corporate financing costs, will become "more stable," with volatility tending to decline. Ultimately, the central bank's credibility should compress, not expand, term premiums.

An index measuring volatility in the U.S. Treasury market, the ICE BofA MOVE Index, fell on Thursday to its lowest level since February. This followed a significant rise in the index after the Fed meeting.

However, Morgan Stanley strategists believe the situation in the short-end rate market may be different. A team led by Matthew Hornbach wrote in a report on Monday that a return to brief statements, less forward guidance, and a smaller balance sheet could create the most volatile short-end rate market in a generation. The real regime shift to watch for is here, not a change in yield levels themselves, but a return of short-term rates and the yield curve to their pre-forward-guidance-era behavior.

The Morgan Stanley strategists suggest that the Warsh era may more closely resemble the period when former Chair Alan Greenspan led the Fed.

Greenspan served as Fed Chair from 1987 to 2006, a tenure of 18 years. Compared to his successors, his policy statements were briefer and provided less guidance on the future policy path.

The Morgan Stanley team advises clients to prepare for more pronounced volatility in the U.S. short-end rate market. They recommend holding trade structures that can profit from increased volatility and reducing reliance on the narrow, range-bound trading patterns characteristic of the forward guidance era.