The Federal Reserve did what the bond market expected and raised the fed funds rate by 25 basis points (0.25% for normal people) at its September meeting. Its statement declared, “Today’s policy action will support a timelier return to the committee’s 2% goal.”
But how timely will that return be, and when will the hiking cycle end?
At Potomac, we believe in data over feelings, so we decided to look at the data.
In his speech at Jackson Hole in August, Chair Warsh said, “Over the past 12 months, 54% of goods and services in the Personal Consumption Expenditure (PCE) basket showed prices increases above 3%. This is well below the post-pandemic highs of about 77%, but it remains well above the level of 32% in the two decades that preceded the pandemic.”
He later added, “We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do.”
We view those comments as telling. So we recreated the measure Warsh appears to be referencing, which tracks the percentage of 199 PCE price categories rising at a year-on-year pace above 3%. Using our model, we estimate that a reading of roughly 40% would historically be consistent with 2% PCE inflation.
Figure 1. Inflation Breadth Remains Elevated
Share of PCE Components Rising More Than 3% Year-on-Year
Sources: Bureau of Economic Analysis, Bloomberg L.P., and Potomac. Data as of August 2026.
At a minimum, we suspect the Fed will want to see this measure on a sustained downward trend, and certainly below 50%. That does not necessarily mean breadth must fall all the way to 40% before the Fed is satisfied.
Using monthly data going back to 1998, when headline PCE inflation is above 3% and inflation breadth declines by five percentage points over six months, inflation tends to fall by roughly one percentage point over the following 12 months, based on our model.
That would still leave inflation above the Fed’s target. But combined with the rolling off of base effects next year, when inflation may mechanically look better as comparisons move past the high energy prices of March and April 2026, that could represent enough progress to change the Fed’s calculus.
As such, we think inflation breadth will be one of the most important metrics to watch.
The Two-Year U.S. Treasury Sees All
On the Street, the two-year U.S. Treasury yield is widely viewed as a leading indicator of Fed policy, often moving before the Fed itself acts.
We have seen that again recently with the two-year Treasury yield climbing rapidly following the start of the Iran conflict. It did not wait for the Fed.
Figure 2. The Two-Year U.S. Treasury Yield Often Reacts Very Quickly
Two-Year U.S. Treasury Yield (%)
Sources: Federal Reserve Board of Governors, Bloomberg L.P., and Potomac. Data as of September 22, 2026.
It is a classic example of the old saying that the bond market is smarter than the stock market. If that is true, then a sustained decline in the two-year Treasury may also provide one of the earliest signs that the Fed is done tightening.
Across the last six modern tightening cycles beginning in 1988, the ultimate peak in the two-year Treasury occurred on average about 19 days before the final Fed rate hike.
In four of those six cycles, the two-year peaked before the Fed was finished. In the other two, it peaked afterward. The lag was only two days in 2000, but 84 days in 2023. The 2023 episode was unusual, however, with inflation remaining elevated and the Fed continuing to show another rate hike in both its June and September projections. As a result, the two-year continued repricing higher until October.
On the equity side, stocks generally performed well after the two-year yield peaked. The S&P 500 gained an average of 10.7% over the following six months and 18.0% over the following 12 months. Only one of the six cycles produced a negative 12-month return.
Figure 3. The Two-Year Treasury Historically Peaks Near the End of Fed Tightening
Sources: Bloomberg L.P. and Potomac. Data as of October 18, 2024. Notes: Negative values indicate that the 2-year Treasury peaked before the final Fed hike. Positive values indicate that it peaked afterward. S&P 500 figures are price returns. The ultimate 2-year peak is an ex-post measure and cannot be identified with certainty in real time.
The Problem with Calling the Peak
There is one problem, of course. It is difficult to know in real time when the two-year yield has actually peaked. In hindsight it looks obvious, but investment decisions are not made in hindsight.
We therefore tested a range of real-time confirmation rules. We looked at declines of 20, 30, 40, 50, and 60 basis points from the running cycle high, combined with confirmation periods ranging from five to 20 trading sessions.
We imposed two requirements: 1) the signal had to appear in all six tightening cycles and 2) no more than 50 basis points of additional Fed tightening could occur after it triggered.
The earliest rule to pass both tests was a 50-basis-point decline in the two-year Treasury that remained in place for 10 consecutive trading sessions (or two weeks).
Once that happened, the Fed had already delivered its final hike in five of the six cycles. The lone exception was again 2023, when the regional banking crisis caused Treasury yields to fall sharply before the Fed ultimately delivered another 50 basis points of tightening after the immediate stress faded.
There is a cost to waiting for confirmation, however. Because the stock market is an official leading economic indicator, investors often give up part of the initial relief rally by waiting for the 50/10 signal. That said, waiting does buy greater confidence that the tightening cycle is nearing its end.
And in three of the last four tightening cycles, the 50/10 signal arrived well before the Fed publicly acknowledged that its tightening bias had been removed.
Figure 4. The Bond Market Usually Confirms the End of the Cycle Before the Fed
Sources: Federal Reserve Board, Bloomberg L.P. and Potomac L.P. Data as of March 24, 2025. Note:The 50/10 rule requires the 2-year Treasury to remain at least 50 basis points below its point-in-time cycle high for 10 consecutive trading sessions. Note: Fed acknowledgement dates begin with the 1999-2000 cycle because comparable FOMC communications are not consistently available for the earlier periods because the Fed did not issue public policy statements at every FOMC meeting.
That leaves us watching two things aside from Chair Warsh’s press conferences.
First, inflation breadth. If fewer and fewer PCE categories are rising more than 3%, the Fed may finally start believing that inflation is moving in the right direction.
Second, the two-year U.S. Treasury yield. If it falls 50 basis points from its cycle high and stays there for a couple of weeks, history suggests that the tightening cycle may be coming to an end.
Clearly, the Fed is probably not going to ring an alarm bell alerting investors to exactly when the cycle is at end, but the bond market might.
Weekly “Keeping it Strait” Highlights:
The biggest story for investors may be that bond yields appear to have stabilized after the Fed’s decisions to raise rates. This suggests that the bond market views Chair Warsh’s desire to curb inflation as credible, which in turn has caused the bond market to be less volatile.
After shooting back up to $100 a barrel, WTI crude oil prices have unwound much of that spike and are back down closer to $90 a barrel. Any easing in oil prices is likely to give the market a boost. Positive news about Meta’s Muse app, has also helped to ease concerns about the company’s ability to monetize AI.
The odds of Republicans maintaining control of the Senate has fallen noticeably below 50%. This may not hold, but based on betting market odds, the Democrats have a reasonable chance of taking control of the U.S. Congress.
