Good morning investors,

The Fed decides at 2pm, and the market has all but stopped debating whether. Fed funds futures put a quarter point hike at 92.5%, up from 33% a month ago, which would be the first move of Warsh’s tenure and the first hike of a new cycle. The 10-year sits right at 5.00% into it, the 30-year at 5.37%, with oil holding above $100 despite easing slightly, Brent near $108. Futures are modestly higher as we look at a market that has done most of its flinching already and now waits for the framing that matters more than the move.

I’ve said for weeks I didn’t think they’d hike, and that ultimately looks like it is going to be the wrong call. That doesn’t mean that I believe they should hike though. Rather than relitigate my views, I want to spend today on what actually matters for how you’re positioned, because the decision itself is nearly priced and the more important shifts are underneath it. Two of them stand out. What the Fed signals about a cycle, and the quieter change that a 5% Treasury has made to the entire investment landscape.

Why This Hike May Do Less Than It Looks

Start with the decision, because there’s an argument the hike is more about credibility than economics. The Fed has spent months emphasizing that inflation is too high and that it won’t be tolerated. After firm inflation data, declining to act would look inconsistent and would hand critics the story that the Fed caved to political pressure to stay put. So part of what happens at 2pm is the Fed protecting its word, not just managing demand.

That matters because a hike aimed at credibility runs into a problem being that a lot of today’s inflation is close to untouchable by interest rates. Energy, healthcare, insurance, education, the war driven price pressures. Raising the funds rate 25 basis points does nothing to produce another barrel of crude or another gallon of diesel. Rate hikes work by suppressing demand, slowing housing, weakening investment, and tightening financial conditions, none of which addresses a supply shock. This is the core of why I doubted the hike, and it remains true even as they deliver one.

A meaningful chunk of current inflation may fade on its own. Work I’ve seen estimates that temporary and unusual factors, things like tariffs, memory pricing, and energy, are adding something like 1.6-1.7 points to PCE inflation right now, and much of that could roll off over roughly six months, potentially pulling PCE down by around a percentage point without the Fed doing anything. If that’s right, the risk is that the Fed tightens into an inflation rate already on its way down. That doesn’t mean the hike is a mistake, but it’s why I’d weight what Warsh signals about the path far more heavily than the move itself. The market has this framed correctly, pricing only 45% odds of another hike in October and 30% in December. A discrete step that pre-commits to nothing is the good outcome. Language that reads as the opening of a campaign is the one that would sting.

The 10-Year at 5% Is a Level to Respect, Not to Fear

The 10-year through 5% is the headline, and I want to be measured about it, because the round number pulls people toward a reaction the history doesn’t support. Yes, higher risk-free yields raise the bar for stocks and pressure the multiple investors will pay. That mechanism is real and I’ve flagged it all year, but 5% is a psychological and valuation marker, not an automatic red line, and there are three things worth separating.

First, why yields are here. A 5% yield driven by strong nominal growth is a different animal from one driven by collapsing confidence or runaway inflation. Real time growth is running strong, and long dated analysis going back to the 1930s shows P/E ratios have actually been positively correlated with yields in the 4% to 6% band. A rising 10-year doesn’t mechanically force multiples down at every level. Right now it’s a mix of healthy growth and genuine inflation and supply pressure, which is why it deserves respect rather than panic.

Second, the speed. A gradual grind to 5% is manageable. A rapid, disorderly move is what breaks hedges, forces selling, and tightens conditions abruptly. We’ve moved quickly, which is the part I’d watch.

Third, and most important, duration over level. As one strategist put it well, 5% doesn’t break anything the day it arrives. It breaks things twelve to eighteen months out, when borrowers who locked in 2% to 3% debt have to refinance at 6% to 8%. The maturity wall was moved during 2020 and 2021, not removed. Housing feels it first, with 30-year mortgages pushing toward 8% and transactions freezing as no one with a 3% mortgage will sell. Commercial real estate, leveraged loans, and private credit feel it later, as the refinancing clock runs. This is why the honest framing is that there’s no single yield at which the economy suddenly snaps. Stress builds gradually through refinancing cycles. At this stage 5% is a valuation adjustment, not a systemic threat, but the margin for error is narrowing, and how long we stay here matters far more than the fact we’re here.

The Real Shift: Bonds Are an Alternative Again

Here’s the change that I think matters most for how portfolios get built from here, and it’s gotten less attention than it deserves. For the last fifteen years, with bonds yielding 1% or 2%, equities essentially had the field to themselves. If you needed a real return, you had to own stocks. That is no longer true.

You can now build a high quality, short-duration fixed income portfolio yielding around 7%, with under three years of duration and roughly A minus average credit, without taking long duration interest rate risk or full equity volatility. Many institutions, pension funds, endowments, foundations, carry long term return requirements near 7%. If they can approach that through high grade bonds, the structural need to overweight equities weakens. Equities have gone from uniquely compelling to merely reasonable, because for the first time in a very long while, there’s a credible low risk alternative that pays you to wait.

This doesn’t make me bearish, and I want to be straight with you about that. It raises the hurdle and stocks now have to earn their place against a 7% bond rather than against cash paying nothing. That means earnings growth has to do more work to justify prices, and it means quality matters more than it did, because the marginal dollar has somewhere else to go. It’s also, notably, a reason the long end itself is getting more interesting. When the 10-year reaches 5%, historically the vast majority of forward periods have been attractive environments to own bonds. I’m not calling for aggressively piling into duration, since heavy supply could push yields higher still, but for the first time in years, adding some high quality fixed income is a real decision rather than an afterthought.

Why I’m Still Constructive on Equities

None of that tips me bearish on stocks, because the earnings and the setup underneath remain strong. Underlying earnings growth is running around 10% organically, and even if the extraordinary 20% to 25% pace of recent quarters slows, absolute profits can keep rising. Private investment sits below a normal cyclical peak, housing especially, which means there’s latent upside rather than a mature, exhausted expansion. A recovery in housing and private investment could add meaningfully to aggregate S&P earnings over time. That’s the market of the E point intact: profits are carrying this, and they haven’t clearly peaked.

Sentiment is the near term thing I’d weight. Investors are unusually pessimistic after a string of weak sessions, and there’s real cash on the sidelines that went defensive ahead of today. Major peaks don’t usually form while everyone is cautious. They form after sentiment turns euphoric. That argues for a possible sequence that runs opposite to the fear: the Fed delivers the expected hike, the immediate uncertainty clears, investors conclude further hikes are less likely, yields stabilize, and cash starts moving back into equities. A widely expected hike can become the thing that unlocks a rally, precisely because it removes the not knowing. The history supports it, too. Across seven first hikes since 1988, the S&P fell about 4% over the following six weeks, then recovered all of it over the next five to six, and was up around 9% twelve months later, positive in every episode but 2022. The first day of recent hiking cycles has actually skewed bullish.

What I’m Watching Today

The decision at 2, but far more the framing at 2:30. One-and-done language that preserves flexibility is what the market wants. Any hint of a campaign is the risk. Then the 10-year’s reaction, which tells you whether this was mainly about the Fed or mainly about bond supply. If the Fed hikes and yields fall, tightening restored some credibility. If it hikes and yields keep climbing toward 6%, the pressure was never really about policy, and that’s the scenario that matters. Credit spreads stay my tell for rate risk becoming credit risk, and they remain tight, which is genuinely reassuring on a day like this.

Best regards,

Dan Sheehan [email protected]

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Market Pulse with Dan Sheehan is a personal market commentary newsletter and is independent from my employer. The content is provided for informational and educational purposes only and reflects my views as of the publication date, which may change without notice. Nothing contained herein should be construed as personalized investment, legal, tax, or financial advice, or as a recommendation to buy or sell any security. Any positions discussed represent my own views and may not be suitable for every reader's objectives, financial situation, or risk tolerance. Information is derived from publicly available sources believed to be reliable, but accuracy and completeness cannot be guaranteed. Readers should conduct their own research and consult their own professional advisers before making financial decisions.

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