The Federal Reserve entering its quiet period ahead of the next FOMC meeting and the first with Kevin Warsh as Chair. Today we update our Fed Reserve Sentiment Model and model, which paints a picture consistent with recent macro readings: Labor Market sentiment has continued its rapid improvement, while inflation has become the most negative category. Inflation is the clear dominant macro concern today, accelerating significantly since the start of the Iran war. High inflation has led to Monetary Policy sentiment shifting hawkish as well.
Labor Market sentiment used to be negatively correlated with the unemployment rate, and the consecutive improving Labor sentiment readings suggests the current strong labor market is likely to continue. In the meantime, correlation between Inflation sentiment and actual inflation is now negative, implying that like investors, the Fed views inflation as an increasing risk.
In addition, Macro Outlook sentiment has diverged from still-strong Current Economic Conditions sentiment. Historically, current conditions tend to follow changes in the outlook with a lag. This suggests an increased risk of slower economic growth in the coming months.
Consistent with the Fed sentiment signals, the 10-year yield decomposition shows inflation-driven risk—not Fed policy risk—as the primary driver of yields. Still too strong core inflation trends remains the biggest risk of 10yr yields moving materially higher.
Hawkish, Inflation-Driven Tilt Ahead of Warsh’s First FOMC: Since Kevin Warsh took over as Fed Chair on May 22nd, Fed speaker sentiment toward the Labor Market has improved, consistent with signs of still firm labor demand. Fed sentiment toward the Current Economy and Manufacturing have also improved. The remaining 9 of 14 categories have declined, especially for Equity Market and Macro Outlook. While none of the documents released since 5/22 originate directly from Kevin Warsh, the model’s readings still capture the broader Committee’s communications and characterizes the tone of the institution through the Chair transition.
With the unemployment rate stabilizing at 4.3% since March, Labor Market sentiment has rebounded, continuing to extend the move off a recession-like low in December. Importantly, the slope of this improvement from the 4Q25 trough is milder than prior recoveries during the Volatile Labor Sentiment period: both September 2024 and January 2023 saw Fed sentiment rebound far more sharply. As 22V economist Gerard MacDonell notes (HERE), the employment report on Friday fits the continued expansion theme and is probably somewhat hawkish for rates.
Inflation is now the dominant concern for the Fed and Investors: Our investor survey highlighted that investors regard inflation as the biggest risk to economy, a view consistent with Fed sentiment: across all 14 economic categories, Federal speakers now treat inflation as the principal concern. At the onset of the Iran War (2/28), Inflation sentiment was mildly negative; today it is the most negative category, marking a dramatic deterioration since the start of the war. Alongside this drawdown, Monetary Policy sentiment has flipped from firmly positive to one of the most negative categories. As a reminder, we define positive Monetary Policy sentiment as dovish and negative as hawkish, so this shift signals a decidedly more hawkish stance.
Historical correlations between Inflation sentiment and CPI moves have been mixed. Since last November, inflation sentiment has been negatively correlated with CPI prints, especially since the Iran War. The conclusion is that the Fed views incremental inflation data as an increasing risk.
A widening divergence between current conditions and the forward outlook: Current Economic Condition sentiment and Macro Outlook sentiment have historically been highly correlated, but recent readings show the two diverging: Current Economic Conditions sentiment remains elevated, while Macro Outlook sentiment has deteriorated into negative territory. This drawdown reflects the negative Macro Outlook signals that our Federal Reserve Sentiment Model (Whitepaper HERE) detected in Governor Jefferson’s speech on May 27th and Governor Bowman’s speech on May 29th. The specific quotes from Bowman (HERE):
“The U.S. economy has been resilient, but the labor market remains vulnerable to adverse shocks and PCE inflation has moved up, due largely to higher energy prices. And my outlook remains influenced by the conditions resulting from the conflict in Iran.”
Jefferson (HERE):
“I expect inflation to decline later this year as the effects of tariffs and the energy shock wane, but I view risks around my inflation outlook as tilted to the upside.”
In both cases, the deterioration in Macro Outlook sentiment stems primarily from inflation. Based on prior patterns, Current Economic Condition sentiment tends to lag Macro Outlook sentiment for several months, and current deteriorating outlook suggests economic slowdown risk over the coming months.
Our current 10-year yield decomposition shows that risk sentiment is the predominant factor explaining the 10-year yield’s return. This indicates that higher inflation and the heightened risk-management it creates is the key driver of the yield level, not Fed Monetary Policy sentiment. The implication is that, even though Fed Monetary Policy sentiment has flipped in recent readings, changes in inflation sentiment are likely to exert greater influence on 10-year yields.
