What We Think the Fed Will Do
Tariffs, potential tax legislation, the conflict between Israel and Iran, the Russia and Ukraine war, and the list of economic and geopolitical uncertainties continues. However, the objective of fixed income is that investors can remain somewhat calm even in uncertain times while generating income. Inherently, this assumes your fixed income manager has not made your fixed income holdings a big bet on interest rates or credit spreads (bond risk premiums). As we have discussed in the past, we don’t think fixed income portfolios should be managed as bets. As always, we are currently constructing portfolios based on our combined views of near-term Fed action, the range of outcomes for Treasury yields, and our views on credit spreads.
The Fed continues to take a wait and see approach, even as it seems every Fed reporter, the President, and equity market participant wants the Fed to cut the Fed Funds rates immediately. However, the Fed has said ad nauseum that they are data dependent and they are not trying to predict economic outcomes in an uncertain world. Since the recent data implies the economy is relatively healthy, the Fed has not cut the Fed Funds rates since November 2024. The Fed is in a tough spot with the looming tariff uncertainty, which the Fed is concerned may be potentially inflationary rather than just a one-time price adjustment. While the Fed has a dual mandate of price stability and maximum employment, we think if inflation is a bit above 2% but well below 3%, the Fed will prioritize the stability of the labor market rather than forcing 2% inflation. However, the Fed does not want long-term inflation expectations to get reset much higher than 2%. We think the Fed will likely cut once or twice this year, but if tariff risks subside and the economy stays strong, there is a possibility of no cuts. We think a 3 or more cut scenario is unlikely unless a recession seems imminent, which is not currently our forecast.
Regarding interest rates and Treasury yields, we continue to think an intermediate duration makes sense as the Fed is more likely to cut rates than raise rates so we don’t think a very low duration portfolio makes sense. (Reminder: the Fed only directly controls the Fed Funds rate which is the overnight rate between banks on excess deposits). A very high or low duration fixed income portfolio is effectively a large bet on interest rates. On the other hand, an extremely conservative portfolio of Treasuries or on the other end of the spectrum a very risky high yield portfolio is a big bet on the economic outlook. Additionally, a very short duration portfolio or money market account exposes investors to significant reinvestment risk. If interest rates do decline, these investors have not locked up current rates for any significant period of time. However, those who own intermediate corporate bond portfolios have locked in rates / yield for longer and will benefit from total return (bond prices increasing) if/when rates fall. We strongly believe the 3-7 year Treasury yields could decline significantly in a risk off scenario due to escalated geopolitical uncertainty, or a mild or moderate recession. We would then reassess our interest rate view and adjust portfolios accordingly. Notably, we are not encouraging investors to take significant duration risk and lock up rates for longer (we recognize this could potentially make sense for a small portion of investors). We do not see meaningful downside to the 10 and 30-year Treasury yields given existing deficits, growing government debt, and potentially fading foreign interest in U.S. government debt. Additionally, the potential tax bill could add another $2.8T to the government deficit over the next decade per the nonpartisan CBO (Congressional Budget Office).
In regards to credit spreads/risk premiums, they remain quite tight by historical standards. (Reminder: credit spread the additional yield or risk premium earned on a bond in excess of a Treasury with the same maturity). We think this is due to a combination of factors including the tremendous amount of liquidity created during Covid, the thirst for yield, the stock market near all-time highs, and continued economic growth. High yield spreads remain near 25-year lows and the argument to be overly exposed to high yield is weak at best. On the other hand, we think the total return prospects for investment grade intermediate corporate bonds are good regardless of whether growth is strong, slow, or even slightly negative in a recession. Investment grade spreads don’t usually widen by more than 1% during sell-offs, while high yield spreads could easily widen by 2-3+%. In a recessionary environment, the decline in rates would provide a meaningful buffer to any price risk for intermediate investment grade bonds. Additionally, high yield companies are more likely to default in a recessionary environment given their weaker balance sheets, so we remain conservatively positioned.
The world is an uncertain place, always has been and always will be; however, a fixed income allocation can potentially serve as a source of cash flow and capital preservation. Thus far in 2025, many fixed income strategies have outperformed equities with much less volatility. We continue to favor owning an intermediate duration, high quality portfolio of corporate bonds and preferreds. We would strongly discourage investors from chasing yield given tight credit spreads and significant economic and geopolitical uncertainty. We think owning individual securities is the best way to gain fixed income exposure as investors can be more discerning regarding security selection, credit quality, duration, while retaining the option to hold to maturity.
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