Insights

Q2 Review – Liberation Daze

We are the proverbial “frogs in the boiling water” in that at the start of April most people thought that global trade was going to be redefined and even decades old strategic alliances were coming to an end.  As “Liberation Day” came and went, followed by pauses, reversals, and occasionally amplified threats U.S. trade policy has quickly become much more livable than originally thought.  It appears that episodes of “face saving” from foreign politicians and their negotiators will morph into self-preservation in the form of accepting some level of increased trade-related revenue being paid to the U.S.  Outsized tariffs hurt the countries running a trade surplus more than it does a trading partner with a trade deficit.  Originally, the tariff conversation was given a more noble tone that it was to stop the fentanyl crisis, or slow the pace of newcomers, and possibly achieve more fairness with our trade partners (who could be against less fentanyl or more fairness) but the portions of the argument for tariffs have increasingly been toward the goals of more revenue and increased job market prospects.  What started the quarter as being the end of the world as we know it, became the current operating environment. 

In roughly 90 days, the U.S. stock market experienced a nearly 25% gain while Treasury bond yields initially shot up 60 basis points into the middle of the quarter only to recover more than 50% of the move by the end of the quarter.  Much of the Treasury market move was related to a combination of the U.S. losing its final “AAA” credit rating at the same time the de-dollarization, or dollar abandonment theme was getting traction.  On May 16, Moody’s Investors Service downgraded the U.S. sovereign credit rating due to concerns about the rising national debt, persistent deficit spending, and an elevated debt to GDP ratio.  Last quarter, we anticipated that the de-dollarization theme would lose steam because the reality is there isn’t a near-term alternative currency for global trade.  We didn’t expect the Moody’s downgrade, but we can’t blame them for their action given the size of deficits, the amount of debt, and the cost to finance the debt, especially this deep into a non-recessionary period.  We would have said “this far into a recovery” but Q1 GDP came in at an annual rate of -0.5%.  At the time of the writing of this piece, the Atlanta Fed GDPNow model forecasts a seasonally adjusted Q2 GDP of 2.6%. 

The fear and uncertainty of the trade environment drained confidence out of consumers and small businesses.  The cost of tariffs didn’t materialize in broad measures of prices as the Fed and many economists predicted.  That may be a function of the temporary pause in the “reciprocal tariffs,” or it is possible that exporters to the U.S., their suppliers, importers, and domestic retailers are shouldering the brunt of the cost, for now.  PPI is elevated as compared to CPI so consumers may be insulated from the effects up to this point.  For the month of May, Core CPI rose by less than analyst estimates for the fourth month in a row.  On a Month-Over-Month basis it only rose by 0.1% as compared to April and on a Year-Over-Year basis it rose by 2.8%.  Employment data has been slightly mixed at times during the quarter but since the end of the quarter, we have seen strong numbers. For the month of June, unemployment fell to 4.1% after spending the prior three months at 4.2%.  Although pundits try to offer a “don’t believe your lying eyes” unique twist on the employment data, point out that nearly 75% of the job growth is in hospitality, or that state and local units of government experienced a jump in new jobs, an unemployment rate of 4.1% is “full employment” so at the 100,000 foot level, the employment environment is strong.  Despite the data, consumers are anxious about the impact of tariffs and what it means for the job market.  Domestic consumer confidence unexpectedly fell in June, below all forecasts collected by Bloomberg.  In the middle of the quarter, consumer sentiment fell to the second lowest level on record.  As the quarter came to a close, and some of the tariff fear subsided, sentiment recovered, which was the first improvement in six months. There’s no doubt about it; we have been operating in an environment with an unknowable outcome.  Markets tend to not like uncertainty, but the domestic stock market recovery was an impressive climb up the wall of worry. It will be interesting to see how markets react when and if trade chaos subsides.  If the trade deals take the scenario of a trade war off the table, and if inflation and employment metrics continue at the current healthy levels, it may be the Fed who will have to navigate their own wall of worry.      

Over the course of the quarter, 10-year Treasury yields moved slightly higher from 4.2% to 4.23% and 10-year high quality municipal yields rose from a yield of 3.2% to a yield of 3.21% as the quarter ended.  Taxable bond indexes experienced annualized year-to-date total returns of between 4.0% to 4.2% and municipal bond indexes experienced total returns of between -1.0% and 1.0% for the quarter.  Partly due to a glut of issuance, along with some buyer uncertainty, long-term municipal indexes experienced losses on an annualized year-to-date basis of 2.7%.      

Q3 Interest Rate Outlook – The Big Beautiful Bill’s Greatest Accomplishment is (Some) Clarity

Following the close of the second quarter of 2025, the Trump Administration’s Big Beautiful Bill (BBB) passed both Houses of Congress.  It averts the debt ceiling crisis (again), and it advances the Trump tax and spending plans.  More important, it offers some much-needed clarity for consumers, businesses and all economic operators that need to navigate the U.S. economy.  On the surface the BBB adds $2.4 trillion to the deficit over the next decade, using the Congressional Budget Office’s (CBO’s) scoring.  As deficit hawks we are not proponents of kicking the debt and deficit can down the road. The Administration has offered some plausible objections to the CBO’s assessment.  First, tariff revenues are not considered in the scoring, and it appears that the end result of the trade negotiations will be the net addition of trade-related revenues.  Whether the burden of those taxes fall on the shoulders of foreign suppliers and producers or if it is born more by domestic retailers and consumers feeds into the Trump administration’s other assertion.  They are promoting the idea that GDP growth will be stronger than the CBO’s estimate, nearly 1% higher.  If the Trump administration is correct, reality could be that the BBB is more deficit neutral than broadly thought.  There is much to criticize about the bill but hoping for the worst-case scenario to be our eventual reality feels a bit like betting on the sun exploding, if you bet right and “win” you still lose.

The ever-changing dynamics of the interplay between Fed policy, tariff dynamics, and the BBB results in a calculus that is too complex for anyone to know the final result. Many people are saying there isn’t anything in the BBB that will meaningfully stimulate growth.  We have referenced how stimulus dollars given to lower income people offered a larger velocity than dollars allocated to higher income taxpayers.  The change in taxation of tips and overtime is an intriguing use of forgone revenue, if it is a fair synthesis to think the velocity of those dollars may make the change a good investment.  It may also help to facilitate the ability to invest and grow in areas where qualified labor is scarce.  At a minimum, it gives another swath of people an option to get into a better financial situation.  Many others say that tariffs are a drag on economic growth. Marginally, that may be the most likely scenario absent the context of who is bearing the brunt of the burden and whether they prompt manufacturers to produce more domestically. With the labor market in a solid position, some favorable BBB expensing provisions, and a “known” tax landscape we anticipate that small business will be more eager to invest and expand.  Last quarter we said that many Trump policies seemed to be such that if there were felt to be mistakes, there was room to go back through the door from which they came.  The fluidity of the tariff negotiations and announcements to adjust some aspects of the immigration stance appear to be showing that there is a willingness, and possibly the expectation, that finding a final position is expected to be an iterative process.

"On the other side of the coin, it is uncertain where tariff levels will land once the final negotiations are settled."

During the last quarter, signs of inflation softened, and employment environment metrics moved around slightly, but the labor market is historically strong.  The Producer Price Index (PPI) saw elevated cost pressures as compared to the Consumer Price Index (CPI) which may indicate that as of late, producers and retailers may be absorbing more of the changing cost of trade as compared to the final consumer.  The fact that the current unemployment rate is 4.1% as compared to a long-term average of 5.67% (Source: ycharts.com), there are 1.1 jobs per job seeker, and the year-over-year CPI is 2.4% as of May, suggest the Fed policy at the current rate does not obviously call for easing.  The Fed’s own indication has been that there will be two cuts in the remainder of 2025, which is in line with the market’s view.  President Trump has suggested that Fed Chair Powell may be a touch slow in lowering rates.  As compared to many other developed nations, our central bank rate is roughly 2% above the median, but the hard data doesn’t suggest that there would be a material difference between a cut at the July meeting or waiting until September.  The Trump Administration is possibly correct in saying that there is an opportunity cost to having the Fed Funds Rate unnecessarily high.  The amount of U.S. Treasury debt to be rolled over during the balance of 2025 is expected to approach $4 trillion and since a large amount of outstanding debt is short-term, higher than necessary short-term rates would exacerbate the deficit and would add to the amount of federal debt.  If short rates are anchored higher than necessary by Fed policy, and if current policy is approximately one percentage point above a neutral policy, the annual cost to finance just the debt rolling over for the balance of 2025 would be approximately $40 billion greater on an annual basis.  Higher rates flow through credit cards, auto loans, other types of borrowings, and potentially even mortgage rates (most mortgages are more impacted by the intermediate and longer yields offered by the bond market).  On the other side of the coin, it is uncertain where tariff levels will land once the final negotiations are settled.  Chair Powell has recently said that absent the tariff conversation, the Fed would have likely lowered rates already.  Our expectation is that tariffs will be high enough to raise revenue and offer some benefits in the form of increased domestic manufacturing but low enough to incent foreign trade partners and producers to accept lower margins to sustain demand.  Unlike the supply chain disruption that was met with free-flowing stimulus dollars, it is not anticipated that the inflationary episode that tariffs present will probably be a one-time muted jump in prices.  Stated another way, unlike the inflation tinder from 2020 through 2024, tariffs aren’t likely to offer a scenario where prices grow on a sustained basis.  Fed policy missteps have consequences, as we’ve seen several times over the past decade. We are supportive of an independent Fed and currently they have a difficult job, but the downside of being too restrictive feels like it outweighs the consequence of meeting the market in the middle by telegraphing that cuts feel appropriate as the next moves (we might suggest they indicate a cut is coming with a hawkish message).     

The Fed has moved the goal post on the market over the past quarter.  When sentiment data fell off a cliff in response to the tariff threats and possible trade war, the Fed said they wanted to wait to see if the “hard data” (metrics that are activity based rather than the “soft data” offered by sentiment measures) would match up with the soft data.  The hard data hasn’t followed, and the Fed continues to be satisfied with their policy position.  Now, Fed Chair Powell has indicated that tariff uncertainty is a reason to keep policy tilted toward a restrictive position.  The position seems odd because our read of the market is that more people expect tariffs to have a greater chance of chilling economic activity than sparking sustained inflationary pressures.  We seem to have moved from a “data dependent” Fed to one that is now using a “management by feel” approach.  To be fair, there is a scenario where prices and demand could be in flux because of tariffs.  If they are high enough and absorbed mostly by consumers, there could be a rush to buy before punitive tariffs were imposed.  We saw some of this with car purchases and other areas earlier in the year, but demand could be pulled forward, causing prices to rise in the face of elevated demand (and getting profits when you are most able) which could very well be followed by an economic lull.  That’s not our forecast but it is a basis for the Fed to assert their independence and manage their credibility by following the policy playbook they laid out in their most recent “Dot Plot” policy forecast. 

One formerly headline-grabbing aspect of the Trump White House has faded off into obscurity.  The Department of Government Efficiency (DOGE) may not have come close to the goals mentioned at various rallies, but it could have served an interesting purpose.  Stay with me because this is not some “fan” singing the praises of Elon Musk or President Trump.  In the book Antifragile, author Nassim Taleb offers that systems that are never stressed become weaker over time.  Like exercising a muscle, it becomes stronger with micro tears and stress.  He surmises that financial systems, and other forms of organizations, become susceptible to catastrophic failures if they aren’t more frequently stressed.  Recessions used to be the mechanism by which malinvestment was remedied.  Looking at the history of recessions in the U.S., according to Bloomberg, recessions covered 40% of the 19^th century, 15% of the time since WW2, 5% since the 1990’s, and only 1% of the past 16 years. Politicians and monetary authorities seem to understandably avoid recessions, but it appears to be hand in hand with persistent deficits and a higher degree of public spending.  In past editions of Insights, we covered how lately the multiplier of some significant sources of public spending is less than 1 (meaning you borrow a dollar for a public purpose and the economy may get less than a dollar of value in return). According to analyst Vincent Deluard of StoneX, half of government spending is structurally growing by 10% a year, which is impacted by the aging U.S. population.  We’ve also established in recent issues of Insights that the U.S. tax revenue relative to GDP is above the median of developed countries, so we have more of a spending problem than we have a “paying for” problem.  The spirit of DOGE felt more like public shaming rather than returning the precious resource of tax revenues to taxpayers or maximizing the benefits of public spending for those in need of assistance. There were outrageous examples that most critical people would see as unacceptable waste.  It is too bad we couldn’t have weighed the superfluous spending against a yardstick that most people could have supported like assistance for the elderly poor.  Course correcting the malinvestment and lack of efficiency and accountability in public spending could end up being a gift to future generations. Government rarely ever experiences a recession.  It seems like it is a system that needs stress to make it better for both taxpayers and recipients of services.

Also, at play for our lack of fiscal discipline may be the equivalent of doom spending on a large scale. A 2010 study by the International Monetary Fund found that adjustments to fiscal policy in advanced economies found they were more sensitive to rising debt at low levels of debt than at higher levels of debt; beyond a certain point debt resulted in a smaller change in budget policy.  The cost of debt may factor in the equation as well.  For much of the past 15 years, the cost of debt was low and the real cost of debt relative to the pace of GDP growth was more sustainable than is currently the case (the real cost of issuing U.S. government debt is currently high on an historical basis).  If debt and deficits seem to be an insurmountable problem, we collectively may not have the will to meet the moment with productive and lasting solutions. If the Trump Administration is wrong about tariff revenue and GDP growth and the BBB simply adds trillions of dollars to the U.S. debt, real yields may climb higher.  We would see inflationary policies as a “solution” to the debt burden relative to GDP or financial repression in the form of lower central bank rates as a way of making the cost of financing the debt more manageable. Currently the U.S. is paying more than $1.2 trillion a year in interest on our debt and we have the fourth largest interest bill relative to tax revenue in the world.  It feels like a “go for broke” moment in that we will grow our way out of this mess, or we will be mired in it for a long time.

"We think the timing of cuts will depend on tariff uncertainty decreasing and the degree of demand pull-forward that the 'final' tariff and trade agreements generate." 

The purpose of the preceding paragraphs was to set the table for the reality that the range of economic outcomes is disturbingly wide.  If the Trump tax and spending plans are able to sustain consumers and spark business investment and if the perpetuation of federal deficits is diminished, there may be a positive path toward lower borrowing costs and stabilization of the U.S. debt to GDP ratio.  If growth is slower than the White House expects, especially if a recession were to set in, the expansion of the federal deficits and increased debt burden could demand higher borrowing costs, especially for long-term debt.  The move would buck the past experience of long bonds performing well in a recession but it is more a function of the market’s outlook for the supply of new Treasury debt than it is the historic response which is based on diminished risks of inflation (which erodes the value of a stream of fixed-income cashflows). At the time of the writing of this piece, the U.S. 10-year Treasury yield sits at nearly 4.42%.  The tepid inflation environment and robust job market provide the Fed the luxury to wait for more directional clarity, or at least a directional trend, before making change to their policy stance.  In late 2024 when the Fed cut rates by 50 basis points, and two 25 basis point cuts, respectively, during the final four meetings of the year, the policy change occurred following clear bond market signals in the months prior to cutting rates (mainly through falling 10-year Treasury yields).  The series of cuts resulted in the 10-year Treasury moving from 3.6% to 4.8%.  If 10-year Treasuries break out above 4.6% it would seem we will test a level between the recent high of 4.8% and the floor we are now forecasting is 3.75%.  Thematically, we think the Fed has a good chance of surprising the market with no cut in September and a well-telegraphed 50 basis point cut in December.  We think the timing of cuts will depend on tariff uncertainty decreasing and the degree of demand pull-forward that the “final” tariff and trade agreements generate.  We don’t expect the Fed will move in response to the inflation part of their dual mandate, we expect it will be in defense of the continued health of the employment market that will result in action.  Our view of the yield curve is that we will be looking at a “bull steepener” where short rates fall more than the intermediate segment of the yield curve, and longer rates are anchored at high real rates while the future supply picture for outstanding U.S. debt develops further.         

Municipal Market Developments – Tax Exempt Status Unchanged

Perhaps the most important development since last quarter’s update is that the tax status of municipal bonds was left untouched.  We have touched on the appropriateness of the federal government not encroaching municipal bond interest much as the states don’t tax interest on U.S. Treasuries. It leaves in place a key funding mechanism for municipal projects, and it offers an historically safe place for savers to generate attractive risk-adjusted income.  Since President Trump’s first term, when the corporate tax rate was reduced, individuals have increasingly become the dominant force in the municipal bond market.  Innovations have allowed individuals low-cost, more liquid, and increasingly customized ways to gain municipal bond exposure.  Municipal Exchange Traded Funds (ETFs) are gaining share as compared to traditional mutual funds and technology has allowed for a more customized delivery of separately managed account (SMA) portfolios which can now better accommodate state-specific needs, maturity preferences, tax loss swapping goals and other client-specific sources of utility.  The latest data offered by the Federal Reserve show that retail (individual) ownership of munis has ascended to 45.2% of the market, while foreign holders, banks, and insurance companies combined share of the market is not adding up to the level of retail holdings. 

"The change does not occur without stress and scarcity challenges faced by impacted stakeholders."

Earlier we touched on the idea that system stress may result in increased efficiencies and durability of the system in question.  The change does not occur without stress and scarcity challenges faced by impacted stakeholders.  As an example, Los Angeles mayor Karen Bass said “uncertainty from Washington, and a slowing economy, are causing lower revenue projections to the tune of hundreds of millions of dollars” during her recent state of the city address.  The city is facing a $1 billion shortfall and the mayor proposed layoffs of roughly 5% of the city’s workforce, or 1,647 jobs. They aren’t the only city facing challenges, San Francisco projects a shortfall of $876 million, and Chicago expects a nearly $1 billion budget gap as well.  We’ve talked about Chicago’s issues too many times in the past but with debt of $29 billion and unfunded pension liabilities of $37 billion, the debt and the pension absorb nearly half of Chicago’s tax revenue.  It is both a sad and an unfair situation that disadvantages the residents of the future in terms of the ability to deliver services relative to the revenue that will be needed to support the decisions (and malinvestment) of the past. 

Scarcity decisions aren’t limited to major cities.  Mass transit systems were supported by the federal government during the pandemic on the order of $70 billion, until ridership returned to pre-Covid levels. The federal support is nearing its end and ridership hasn’t quite returned to the levels of early 2020. According to an analysis from Bloomberg News, they estimate the largest systems face a combined annual shortfall of $6 billion for years to come.  As a window into the abundance mindset from leadership, advisors, and academics in this area, a thread of common thinking that seems to be prevalent is the idea that if transit “isn’t frequent and when transit isn’t reliable, people stop using it” as said by former Pennsylvania Transportation Secretary and now professor at the University of Pennsylvania Stuart Weitzman School of Design.  There is a concern that cuts to service will result in longer commutes, lost work hours, clogged roads and a setback to the fight against climate change.  There is a fear that reduced schedules could lead to a mass transit “death spiral.” According to a 2015 Star Tribune article, the national average farebox recovery ratio (the percent of system operating costs covered by fares) is around 31% for light rail lines and 25% to 30% for local bus routes, so there must be a way to offer service that is more dynamic to the needs of the fare-paying population.  It is reasonable to think that mass transit is a public good; and to address some of the benefits and concerns mentioned above, it would be appropriate to expect that a meaningful percent of system costs would be subsidized from other sources.  The beauty of local governments is the local population can determine the level at which they want to support system capacity and the level of convenience they desire for their local and regional mass transit options.  Post Covid, usage patterns have changed and seemingly service patterns should incorporate peaks and troughs in demand.  Operating in a scarcity environment may make the systems more equitable for all stakeholders.                

States and school districts are also facing federal funding issues, although from materially different sources.  It is estimated that the DOGE efforts have shrunk the federal workforce by 60,000 positions, and another 75,000 have accepted the buyouts that become effective on October 1.  Maryland’s comptroller estimates that U.S. government jobs make up 6% of their workforce and 10% of overall wages in the state.  Further impacting the state is the loss of $800 million in funding from the US Agency for International Development that was given to John Hopkins University, forcing them to trim 2,000 jobs.  The District of Columbia estimates it will lose as many as 40,000 US government jobs, or 21% of its federal workers.  That kind of change should have a significant impact on the local economy.  Whereas the DOGE-related spending cuts would have been difficult to imagine for impacted state and local governments, the issues facing schools have been something of a slow-motion car crash.  It is a risk we have identified for several quarters.  In short, the Covid cash that districts received, and broadly didn’t need, has largely been spent.  To the unfortunate surprise of administrators, the funds won’t be replenished by the federal government.  To smooth the difference between the level of spending and the sources of funding, school districts are going to the market to issue debt. Public school debt issuance has reached nearly $45 billion this year, a 35% increase from the same period in 2024.  That is compared to a 20% increase in growth for the total municipal market over the same period.  The consensus among municipal analysts is that most school districts are in healthy enough financial shape to support the increased debt burden.  As a reminder, ACG performs in-house credit analysis on our credit exposures, and we had an eye toward this risk last year.  Those districts habitually issuing debt for operating expenses rather than capital improvements tend to be ones we would avoid independent of this avoidable episode.  Skewed by some major muni market downgrades, the overall health of the municipal market was healthy as the quarter ended with the margin of credit upgrades to downgrades that was 1.27X (which supports our assertion that “big” does not always mean an issuer is safe).      

Strategy and Summary – Unusual Times

The calculus of where the U.S. economy ends up, along with the future deficit position is unknowable. If past is prologue, then we will be overconfident about our future and we will hope that things work out, rather than doing the hard work of telling our population to stop expecting the “other guy” to give up their freebee to solve our collective problems.  It may be that the “other guy” is our trading partners and on a comparative basis the U.S. can grow our way out of our looming debt to GDP crisis.  Better yet, since finding efficiencies in an effort to drive profit is what businesses do every day, the burden may fall on the shoulders of those best equipped to adapt and evolve, the suppliers, transporters, retailers and supporting vendors to all points along the supply chain.  If the pain is put upon consumers it may result in a traditional belt-tightening induced recession.  Some of the Trump Administration’s cabinet seems to be serious actors who are less interested in promoting their political team and more interested in making their mark on the future path of the country (there may be some unserious actors too). The two most likely paths we can see are that either Trump’s plan works more than the CBO anticipates and sooner than when the lull from the tariff demand pull-forward slows economic activity, or the CBO is correct, and we amplify the trajectory of our debt to GDP burden on multiple fronts.  We often single out Chicago as an example of what not to do.  Can you imagine if nearly half of federal tax receipts went to servicing debt and retirement benefits? As of 2024, we are sadly not too far off, with 22.4% spent on Social Security and 13% on debt service.  It is a violation of the contract between generations and allowing it to get worse is unconscionable.    

The U.S. economy is at full employment and inflation is approaching the Fed’s stated goal of 2%. Fed Chair Powell has indicated that absent the tariff uncertainty, the Fed would likely have lowered rates toward a neutral stance.  We expect that demand pull-forward may offer a scenario where the Fed keeps rates higher for longer and there could be a market surprise that the Fed doesn’t ease in September and cuts 50 basis points in December.  In response to a hawkish easing cycle, the yield curve should experience a bull steepener, with short rates moving lower than the intermediate part of the yield curve and the long end of the curve will be anchored near current levels until some clarity about the federal deficit and supply of new debt become clearer.  Short-term bonds continue to be a stabilizing part of our strategy.  Cash equivalents and short-term bonds offer a historically attractive real yield.  Farther out we like high quality issues spread throughout the 5-year to the 10-year part of the curve and although we don’t expect much price appreciation on the long end of the curve, real rates are historically high, which has typically been a good time to “go long.”  This time could be different but in more than 30 years of experience in the markets, those tend to be words that lead to bad days for investors.  We are operating in times of seismic change.  Let’s hope this works.

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