What is "The Warsh Shadow Rate"?

 The Federal Reserve faces a growing risk of delivering a September rate hike after Chair Kevin Warsh signalled a more hawkish approach to inflation, although softer incoming data could still keep the central bank on hold, Citi Research said.

Citi said its newly constructed “Warsh shadow rate”, based on the economic and financial indicators Warsh highlighted in his Jackson Hole speech, is close to historical highs typically associated with past Fed hiking cycles. The gauge also tends to lead two-year Treasury yields, suggesting markets may be correctly pricing a higher probability of renewed monetary tightening. 

Warsh’s message has put the Fed’s next move back at the center of the market debate. A strong August inflation reading could turn the September meeting into a live hike decision, threatening to push Treasury yields higher and weigh on gold, while stocks may prove more resilient unless rising rates are accompanied by a sharp jump in volatility.

Warsh placed greater emphasis on measures including underlying inflation, money supply, labour-market claims, financial conditions and equity-market indicators, while playing down inflation expectations, wages and headline nonfarm payrolls. Citi said the indicators Warsh prioritised are predominantly showing a hawkish signal, while many of the measures he downplayed have softened.

The key test will be August inflation. Citi economists still do not expect a September hike, arguing that softer inflation data could prevent one. The bank said a 0.3% or higher rise in core CPI would probably make a hike more likely, while a 0.1% increase could postpone it; the implications of a 0.2% reading would be less clear.

The report also highlights a growing challenge for U.S. Treasury Secretary Scott Bessent. A more hawkish Fed has pushed Treasury yields higher, with the 10-year yield particularly affected, while rising oil prices have added to pressure on the long end of the curve. Citi said it could become harder to keep the 30-year yield below 5.3% if the Fed begins hiking in September.

Citi's historical analysis suggests U.S. equities typically experience some weakness following a first Fed hike, while bonds tend to perform poorly for longer. The bank found equities generally weaken for roughly 50 trading days after the first hike before recovering, whereas bond returns can remain weak for much longer.