By: Paul Morrone
A New Sheriff in Town: Warsh, Oil and the Road to the Midterms
If the second quarter was defined by headlines that made your head spin, the third quarter was defined by who is holding the steering wheel. For the first time in more than eight years, someone other than Jay Powell is setting the tone at the Federal Reserve, and Kevin Warsh has wasted little time making it clear that the Fed under his leadership is going to look and sound different. Add in an unpredictable oil market that reversed the late Q2 price declines, interest rates that hit a 24 year high, and a midterm election that is now just weeks away, and investors have plenty to chew on as we head into the final stretch of 2026.
Before we get into the weeds, the scorecard. The S&P 500 gained a modest 2.3% for the quarter but is about 14% year-to-date. Growth equities powered the index higher through the quarter, reclaiming short-term leadership from value stocks that had led the way during the first two quarters of the year. Internationally, the MSCI EAFE rose just under 1% and MSCI EM pulled back less than 1% with international equities in general giving back some of the leadership we wrote about last quarter. Much of this was driven by volatility in interest rates and a renewed strengthening in the US dollar which weighs on foreign earnings.
A new direction at the Fed
Warsh is not a newcomer to the building. He served as a Fed governor from 2006 to 2011 and had a front row seat to the great financial crisis. In the years since, he has been one of the more vocal critics of the institution he now leads, taking aim at the size of the Fed’s balance sheet, its heavy reliance on forward guidance, and what he has described as mission creep beyond its core mandate. He has also argued that the productivity gains from AI could prove disinflationary over time, which, in his view, gives the Fed more room to bring rates down than the traditional playbook would suggest.
Why does this matter to investors? Under Powell, markets were trained to hang on every word of the post-meeting press conference and every dot on the dot plot. Very little came as a surprise because the Fed went out of its way to telegraph its next move. Warsh has signaled he is far less interested in that kind of hand-holding. Less guidance can mean more independence from day-to-day market noise – which is arguably healthy – but it also means investors should expect more volatility around Fed meetings as traders lose the roadmap they’ve grown accustomed to. Earlier this year, it was predicted that the Fed would be cutting rates and that Warsh would be accommodative to the demands of President Trump, when in reality the exact opposite has happened. Rates were raised during the most recent FOMC meeting and markets are pricing in 3-4 more hikes over the next 18 months. Some mary argue that this is a bit of an aggressive estimate, but goes to illustrate that Warsh is dedicated to fighting the sticker than anticipated inflationary environment that we find ourselves in.
It’s also important to remember that the Fed only controls one end of the yield curve. Short-term rates take their cue from the Fed, but longer-term rates – the ones that drive mortgage rates and borrowing costs for businesses – are set by the market. The 10-year Treasury yield ended the quarter at nearly 5.3%, the highest we’ve seen in over 20 years, as compared to about 4.5% at the end of June. This is a significant move upward that the equity markets handled in stride. A shrinking Fed balance sheet, persistent federal deficits and companies borrowing heavily to fund the AI infrastructure buildout (remember the century bonds?) all compete for the same pool of capital. That means it is entirely possible for the Fed to cut rates while long-term borrowing costs stay stubbornly high, or move even higher. For those holding meaningful cash, carrying a securities-based line of credit, financing real estate or invested in private credit, the shape of the yield curve may matter more than the headline Fed decision.
Oil and interest rates: the push and pull
Here is the rub. As we discussed back in March, an oil supply shock filters into virtually everything we consume, from gas at the pump to fertilizer to the cost of shipping goods to your local store. Crude ended the quarter at roughly $105 per barrel, up from about $75 at the end of June. As long as energy prices remain elevated and the geopolitical picture remains unresolved, the Fed’s path to lower rates is going to be bumpier than some would like. There has been a clear correlation between oil prices and interest rates over the past 12 months, which is consistent with past periods of historical energy price volatility. Until we have a clear and final resolution with the Iranian conflict in the middle east, we expect volatility in both interest rates and equities to remain elevated.
Looking ahead: Q4 and the midterms
On November 3rd, voters head to the polls, and control of the House and Senate will be up for grabs. Historically, midterm years have been some of the choppier stretches of the four-year presidential cycle, with markets tending to wrestle with uncertainty in the months leading up to Election Day and then finding firmer footing once the results are known. Markets don’t necessarily care who wins – they care about clarity, and divided government has historically been far from a death sentence for stock returns. What is on the line this time around is meaningful for our clients in particular: the direction of tax policy (which is always a political hot potato), tariffs, federal spending and the ongoing debate around the Fed’s independence could all shift depending upon the balance of power in Washington come January.
The key to remember is that there is always uncertainty. Looking back gives us the benefit of hindsight and the ability to assess market and economic impacts of events retrospectively. Looking forward will always be fraught with uncertainty, and even AI will never be able to predict what is going to happen tomorrow. The headlines we’ve discussed and their potential impact on markets in the future are simply assumptions as of a point in time and we will continue to share our thoughts as the path from the fed becomes clearer, unrest in the Middle East calms down and as the inflation story continues to unfold.
As we’ve said many times, the headlines will always find a way to keep investors up at night – this quarter it’s a new Fed Chair, oil, inflation and an election, and next quarter it will be something else entirely. Long-term investors who stay disciplined through the noise have historically been rewarded for their patience, and we don’t expect this time to be any different. Please reach out if you have any questions, we’d be happy to discuss any questions or concerns you may have.
Investment advice offered through Great Valley Advisor Group, a Registered Investment Advisor. Great Valley Advisor Group and Nexa Financial Group are separate entities.
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