Bond Markets Reach a Turning Point

Since the beginning of the year, we've asked the question "Which comes first—the slowdown from tariffs and immigration policy or the inflation?" At this point, the economy is confronting both, but the growth slowdown is the more important factor long term. High tariffs, federal spending cuts, and limits to immigration are obstacles to growth, while simultaneously pushing prices higher. Faced with this policy mix, businesses and consumers have become cautious. Consequently, hiring and spending have slowed. With the recent revisions, the three-month average increase in nonfarm payrolls was just 35,000—the lowest level in five years.

Adjusted for inflation, consumer spending has fallen sharply over the past few months. The annualized rate of spending is negative for the first time since 2010, excluding the COVID-19 pandemic time period in 2020.

The conundrum is that the same policy mix is contributing to inflation pressures. Input costs are rising for many goods due to tariffs. Meanwhile, labor costs are edging higher due to a huge 341,000 drop in the number of foreign-born workers in the labor force, which is largely due to immigration restrictions.

Consequently, the unemployment rate has remained low as slower hiring is matched by a fewer people available to work, but wages are ticking higher. Inflation, as measured by the price index for personal consumption expenditures (PCE) has started to turn higher.

We expect the Federal Reserve to put a higher priority on the faltering economy and slowdown in job growth than on the current level of inflation on the assumption that slower growth will cap inflation. We look for a cut in the target federal funds rate—the rate banks charge each other for overnight loans—by 25 basis points to 4.0% to 4.25% at its September meeting and again in December.

The Fed has described its current policy as "restrictive," meaning interest rates are high enough to cool down economic growth and bring inflation down to its 2% target. A few rate cuts would bring it into the range of neutral for the economy. Since economic cycles tend to be self-reinforcing, it's likely that the rate cuts will pull the federal funds rate down to near 3% to 3.25% over the course of the next year.

Fed rate cuts tend to have the biggest impact on short-term rates, since those are most influenced by central bank policy. Intermediate- to long-term rates are more influenced by prospects for economic growth and inflation over a longer time horizon and are less sensitive to changes to the fed funds rate at a given meeting.

Given the stubbornness of inflation pressures and the increasing financing needs of the federal government, long-term yields may not fall as much as short-term rates. The slope of the yield curve is likely to remain positively sloped or steepen further.

For investors, falling interest rates amid a slowing economy suggest that total returns should continue to be positive in the fixed income markets (remember that bond yields and bond prices generally move opposite to each other). With this backdrop, the risk that yields will move back up to levels seen earlier in the year has diminished. In our view, a turning point has been reached that should benefit investments in bonds.

We continue to favor maintaining an intermediate-term average portfolio duration (five to 10 years) in high-credit-quality bonds, such as Treasuries, investment-grade corporate bonds, and highly rated municipal bonds. We would limit exposure to lower-credit-quality bonds, such as high-yield bonds, because a slower economy could put stress on the ability of these issuers to make regular debt-service payments.