Considerable airtime, ink and pixels have been devoted to when the Federal Reserve (Fed) will resume its easing cycle. Chair Jerome Powell’s speech in Jackson Hole has certainly put the September meeting in play. But while Fed policy definitely impacts interest rates in the 0-2-year space, the influence out the US Treasury yield curve varies by market condition. This time around, the influence looks to be in the shortest maturities only, with the longer end more concerned with effectively pricing in the impacts of inflation (which makes fixed income less valuable) and deficits among many other variables, including attacks on Fed independence. So, while savings accounts and money market funds may react in line with the Fed, it is a reasonable forecast now that mortgage rates, which on average tend to price 150 basis points wide of the 10-year US Treasury, may not.
With the Fed having more influence on the short end (roughly overnight to 2 years) of the curve than the long end (7 years onward), the point at which Fed influence ends depends on the specifics of the economic condition and Fed credibility:
- Tech bubble: The easing cycle it prompted saw the Fed reduce their policy rate (the fed funds overnight rate) by 475 basis points from late 2000 to about a year later; the 2-year US Treasury note declined by 250 basis points, the 5-year by 115 and the 10-year by 45. The verdict: the Fed had some influence on the 10-year.
- Great Financial Crisis: The Fed lowered rates by 500 basis points to essentially zero following the crash. This radical shift, and the magnitude of the recession, pulled the curve down significantly, with the two-year falling by 340 basis points, the five-year by 270, the 10-year by 230 and the 30-year by 215. The result: the Fed had significant impact on the entire curve.
- Pandemic: The vast unknown of the Covid era of shutdowns prompted an almost parallel shift in the yield curve. The Fed dropped fed funds by 150 basis points over one month, and the two-year slipped by 105, the five-year fell by 93 and the 10-year fell by 84. The verdict: The Fed’s decision was influential but the magnitude of the curve response was driven more by the complete unknowns of this unprecedented event.
The supposition that the full curve will fall once the Fed cuts is precarious.
That brings us back to the present easing cycle, which began about a year ago only to stall after 100 basis points of cuts. Over that time, the curve has not responded as it has in the past in both magnitude and direction. From September 2024 to now, US Treasury yields have increased from the two-year point onward through the full length of the curve in a significant departure from historic patterns. Specifically, the two-year US Treasury rose 17 basis points, five-year increased 37 and 10-year rose 62. The inflection point on the yield curve at which the Fed’s influence seems to end is now around the one-year point.
The supposition that the full curve will fall once the Fed cuts is precarious. All you need to know is that fed futures is giving around an 85% chance of a cut in September’s Federal Open Market Committee (FOMC) meeting, and the 10-year is floating like a hot air balloon on its own trip. Part of this disconnect is due to the immense pressure on the Fed by the administration, tariffs and persistent inflation, among other long-term risks, all of which attenuates policymaker influence. Bottom line: Don’t assume the things will suddenly revert back to historical trends when the Fed cuts. This time does indeed seem different.
In this environment, our rate forecast has been for a bull steepener, in which the front-end declines and the long end holds or increases slightly. That is why our overall recommendation for investments is in the 1–5-year part of the curve and higher quality selections in that space. This part of the curve has a better chance of following the Fed, with yields falling and prices rising, than the long end which will reflect inflation and other risks.
Sectors in late summer
Whether due to attractive yield conditions or ever-changing headlines, late summer has provided another atypical situation. It is typically a time when spreads widen. But this time, they have remained flat or tightened slightly as demand has remained hot. September could bring volatility. Taking the underlying credit sectors in turn:
- Mortgage-backed securities: Supply is quite manageable, given affordability issues and elevated mortgage rates, while demand has remained steady. Spreads here have tightened a little since the end of July and are in the range of fair value. The missing piece is a catalyst to drive them tighter. Chatter about a potential public offering of Fannie Mae and Freddie Mac has been persistent, though details are thin and it is likely not a near-term event.
- Asset-backed securities (ABS): Supply has waned over the past few weeks, yet demand has been firm, keeping spreads relatively flat. ABS offer value compared to other investment grade sectors. Our process favours traditional ABS segments; the shifts in fiscal policy are creating problems for some of the more esoteric issuance.
- Corporate bonds: Spreads of investment-grade securities are at their tightest levels in more than 25 years as persistent demand for yield is presenting advantageous conditions due to strong corporate earnings and digestible supply. This yield curve has been fairly flat from 10 to 30 year, indicating that corporate treasurers think that rates could decline in the long end. With the overall yield now just shy of 5%, will demand decline just as corporate issuance typically ramps up in September? Too early to tell, especially as so much else is proceeding counter to historical trends. High yield spreads are also tighter over the month as yields continue to draw buyers but spreads are flat to the end of last year. High yield spreads are in the tighter part of their historical range but should remain static in the face of reduced supply and strong demand pushing up yields. Yet we are cautious, deeming the risk/reward unfavourable. Across the rating spectrum, deregulation could prompt mergers and acquisitions (M&A).
- Emerging markets (EM) This broad and diverse sector has performed well of late, with spreads tighter over the past month. While overall valuations are not extraordinarily compelling given that tightening trend, EM provides three distinct ways to express conviction: sovereign debt, corporate issuance and local currency markets that are compelling and are our choice over hard currency sovereigns. We think the US dollar will continue its descent, but not be a smooth line, providing opportunities to adjust positioning.
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