The Federal Reserve is widely expected to keep interest rates unchanged at the conclusion of its July 28-29 policy meeting. Yet, traders are still pricing in a 38% chance of a interest-rate hike as of Friday, up from 12.8% a week ago, based on the CME FedWatch tool.

The disconnect may be the new normal under Fed Chairman Kevin Warsh, who has disavowed forward guidance, or public commentary on the Fed's economic and interest-rate outlook. Investors could pay the price in increased uncertainty and more market volatility for both stocks and bonds.

The case for keeping the federal-funds rate at its current target range of 3.50%-3.75% looks compelling. Employment conditions are decent, the economy is healthy, and the latest inflation reports showed a deceleration in price growth, notwithstanding higher oil prices. These trends collectively argue for the Fed to stay on hold, even though inflation has been running above the central bank's 2% annual target for the past five years.

Absent forward guidance, however, it is harder for the markets to read the tea leaves correctly. The Federal Open Market Committee removed forward guidance from its June policy statement, and Warsh declined to offer clues to prospective policy at his June press conference.

The end of forward guidance implies almost by definition a greater degree of uncertainty about the Fed's plans, says Sonal Desai, chief investment officer for Franklin Templeton Fixed Income. "Warsh wants financial markets to focus on analyzing the economic outlook rather than Fedspeak," she says.

Desai, a member of the Barron's Roundtable, also notes that Warsh's ascension has reinforced the view that this may be a more hawkish Fed than investors have seen in a while. "It is early days, but the repeated emphasis on bringing inflation down to target gives that impression," she says.

The possibility that the Fed will raise interest rates to contain inflation has prompted investors to build more of a "risk-premium" into bond prices to compensate, says Andrew Hollenhorst, U.S. chief economist at Citi. This likely will result in more volatility in bond yields.

The odds described by the FedWatch tool are derived primarily from 30-day federal-funds-rate futures contracts, which reflect the expected path of short-term policy rates. Shifting probabilities reflect revised expectations for short- and long-term yields. Changes in rate odds can influence wider market metrics, such as the equity risk premium (ERP) and credit spreads.

The U.S. 10-year Treasury now yields 4.7%, near levels not seen since January 2025. Much of the recent upward momentum in yields has been driven by surging oil prices and inflation fears as tensions escalate in the Middle East.

The risk premium, as measured in the FedWatch odds, historically has been minimal, particularly in recent years under Fed Chair Jerome Powell. Typically, the odds signaled nearly 100% certainty of an expected rate decision just ahead of an FOMC meeting. But Hollenhorst expects them to reflect a wider range of outcomes in the future, as is the case regarding this week's FOMC meeting.

Whereas the futures market might have priced just a few percentage points of 'premium' before a Fed meeting in the past, it could become more common to see 30% to 50% implied probabilities of an otherwise unexpected rate move, Hollenhorst says. "Part of that is the fundamental uncertainty about what the Fed will do, but part of that is just the extra compensation investors require for bearing that risk," he says.

While Warsh's argument against forward guidance has merit and fans, his approach means the market will have to develop other ways to understand the Fed's reaction function, or its response to incoming data and economic conditions, says Erasmus Kersting, department chair and professor of economics at Villanova School of Business.

Right now, its understanding is lacking, he says.

Confronted by Warsh's silence, many Fed watchers are focused on the utterances of other Fed officials, in particular FOMC voters such Vice Chair Philip Jefferson, Fed governor Christopher Waller, and New York Fed President John Williams.

Waller has adopted a hawkish tone of late, saying he would need to see several months of lower readings to feel confident that inflation is moving in the right direction. Remarks by Williams and Jefferson suggest they are likely to vote in July to hold rates steady.

Still, rising odds of a rate cut in the futures market suggest that markets don't have a firm grasp of the Fed's reaction function under current economic conditions. It is likely that errors in projecting how the Fed will move will be greater with less information, increasing bond price volatility and credit spreads, Kersting says.

In other words, if the futures market prices in a significant chance of a rate increase but the Fed holds rates steady, stocks could rally and short-term yields could drop more than expected, Kersting says.

Alas, the reverse is also true.

Write to Megan Leonhardt at megan.leonhardt@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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July 27, 2026 01:00 ET (05:00 GMT)

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