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The first quarter came in like a lamb and went out like a lion.  Uncertainty surrounding tariffs, government efficiency and global conflicts has resulted in a sharp equity market sell-off.  The tech-heavy NASDAQ has been the hardest hit of the major equity markets, and many noted analysts have lowered their S&P 500 targets for 2025. Bonds have become more attractive, and interest rates declined slightly in the first quarter.  A substantial slowing in the forecast for Q1 GDP has brought the word recession into many conversations.  The huge reversal in momentum stocks caught many investors off guard. Losses are piling up and anxiety is running very high.  Volatility from day to day adds to the angst.  Getting some clarity with respect to tariffs will go a long way in bringing the temperature of the market down.  We should know more toward the end of June (perhaps).

Interest rates declined in the first quarter as equities came under pressure and it seemed as though investors were in a risk-off mood.  Short term rates were unchanged, the 2-year maturity treasury yield fell 32 basis points, the 5-year yield fell 39 basis points and the 10-year yield declined 32 basis points.  This resulted in positive returns for most fixed income indices.  Equities were a different story.  The S&P 500 fell 4.6%, the NASDAQ declined 10.4% and most foreign stocks were positive for the quarter.  The momentum stocks that were the darlings the past two years have been hit the hardest.  Corrections are common but they hurt, nonetheless.

All the uncertainty surrounding tariffs has the consumer and businesses spooked and the outlook for Q1 GDP is very low. Many forecasters think it will be less than 1.0% and the Atlanta Fed’s GDPNOW shows it to be -1.5%.   The odds of a brief recession have risen but remain well below 50%.  Consumers feel worried as equity prices have corrected, while at the same time businesses are bombarded with uncertainty with respect to policy.  It’s unclear when these issues will get resolved but the longer they drag on, the worse it will be for the economy and the equity markets.  Despite all these uncertainties, the consensus view for the U.S. economy for the entire year is pretty good.  The unemployment rate will rise from 4.1% to 4.3%.  GDP will improve each quarter although it won’t reach 2.0% by the 4th quarter.  Inflation will rise but only minimally.  There will be two rate cuts by the Fed.                             

One investment that provides an attractive yield with no credit risk, no premium risk, and very good call protection is the discounted 15-year mortgage-backed security (MBS).   Let’s look at the 4.0% coupon MBS trading near 97.6. The bonds have a 4.9-year average life and yield 4.50% versus 3.90% for a 5-year Treasury note.  Every mortgage that prepays goes back to the investor at 100 so the investor has an additional bump to the yield for that.  These are backed by the government and have excellent liquidity. If an investor wants more prepayment protection, then buy the 3.0% coupon or 3.5% at an even larger discount but it’s unlikely prepayment speeds will increase.   

Investment grade corporate bonds remain one of the most frequently used securities in the fixed income market. They are priced a bit on the expensive side currently. We measure this by calculating the additional yield investors receive versus a like maturity Treasury (risk free) security.  The additional yield is called the “credit spread” and is currently 97 basis points.  This spread traded as wide as 170 basis points in 2022.  It widens and narrows based on the outlook for corporate defaults which in turn is a function of economic growth.  The spread spiked to 400 basis points during the pandemic for a very short time.  Liquidity in this sector tends to be excellent.  Given the economic uncertainty, we prefer higher quality issuers that will have less downside risk if the economy softens and credit spreads widen. 

We have been proponents of buying longer maturity securities for a couple of years.  Extend duration and make sure you get call protection.  Interest rates are the highest they have been since 2006 – 2007.  The economy is clearly slowing and that should force the Fed to cut rates. Equities are rich on a historical basis and have struggled so far this year.  Bonds also generate an attractive level of income.  At this point in the cycle, it seems prudent to reduce risk and wait for a better environment. 

The Fed seems to be on hold until the last half of 2025.  The U.S. economy is at full employment and headline inflation between the 25-year average and the Fed’s stated goal of 2%.  In a vacuum this is an economy the Fed should like.  An ever-changing tariff policy doesn’t seem like it will spiral into a trend of higher inflation.  It feels like it will be a jump in costs which will be shouldered by many entities in the trade equation, so the inflation impact may be somewhat muted.  If tariffs are essentially a consumption tax, they may have the near-term influence of accelerating consumption and creating a lull on the other side of the enactment. Short-term bonds continue to be a stabilizing part of the bond market since cash equivalents and short-term bonds offer an historically attractive yield.  On the other side, we like high quality issues spread throughout the 5-year to the 10-year part of the curve.  That piece of the strategy could benefit in a couple of scenarios.  First, if the conversation about the safety of U.S. assets subsides, or if a dramatic world event occurs, we think people are creatures of habit and the U.S. Treasury will regain its safe haven status. Additionally, if the forgotten consumer displays their exhaustion, the economy will slow, and the longer segment of the barbell strategy should see some appreciation.  A common thread throughout this quarter’s strategy is “uncertainty.”  Against that backdrop we recommend a focus on quality.  Yields are historically high, why not capture most of the benefit without the sleepless nights.  The pace, tone, and approach to global trade policy along with the broader investment market volatility are already taking up too much mental shelf space.

Interest Rate Outlook

Tariffs are generally thought to result in inflationary pressures while slowing global growth. With that said, tariffs generally hurt the country that is in the trade surplus position as compared to the country in the trade deficit position.  Leading up to April 2^nd (“Liberation Day”), when President Trump announced tariffs on many of our major trading partners, it was expected that the announced tariffs would amount to roughly 10%.  When the President hauled out his tariff tote board, he shocked the world with rates ranging from 10% to 49%.  For perspective, average U.S. tariff rates had been approximately 2.2% in 2024 according to the Richmond Federal Reserve Bank.  The same study indicated that the average tariff among World Trade Organization (WTO) member countries is approximately 2.5%.  The market seemed to be prepared for something on the order of 10%, but as informed readers may know the first volley of this trade renegotiation started at something well above expectations.  As it is central to our outlook and forecasts, we will revisit this dizzying topic later in this piece, but we will be forced to continue to wade in the murky waters of the unknowable, in doing so.         

Whereas tariffs grabbed much of the oxygen as of late, the start of the 47^th president’s term was marked by immigration headlines and the cost saving efforts promoted by the Department of Government Efficiency (DOGE).  We try to avoid being political in this Insights publication, so our intent with addressing these developments is through the lens of how we anticipate the changes will impact the economy and bond market.  Border crossings have nearly stopped so the growth of the workforce should slow.  In isolation that may result in wage pressure for lower wage positions.  The efforts of DOGE have uncovered surprising purposes for which funds are dispensed, but the actual cost savings have been modest.  As of April 8th, the DOGE official website shows an estimated savings of $150 billion.  To hit the $2 trillion cost saving estimate originally offered by Elon Musk seems next to impossible.  Republicans narrowly passed the blueprint for the budget, although it may be the case that a full continuation of the tax cuts for the higher-bracket taxpayers may be required to “make a deal.”  This is relevant because the modest DOGE cost cutting will require a commensurate reduction in the continuation of some of the tax cuts to achieve President Trump’s and Treasury Secretary Scott Besset’s goals of reducing the deficit to 3% of GDP. The conservative lawmakers needed to pass the budget blueprint have been assured that there will be $1.5 trillion in savings while preserving essential programs.  According to taxfoundation.org, using 2022 tax year data, the top 10% of earners paid approximately 72% of all income taxes collected.  The savings needed to achieve Republican’s stated goals will need to come from the segment of the population that pays the most meaningful amount of the tax burden. Since Republicans used “current policy baseline” which treats an extension of the 2017 Tax Cuts and Jobs Act tax cuts as a continuation of law, it magically cuts $3.8 trillion from the proposed budget’s price tag.  The Committee for a Responsible Federal Budget estimates the Senate’s plan would add at least $5.8 trillion to the federal deficit over the next ten years. The DOGE spending cuts will likely be a drag on growth, while the continuation of deficit spending may have the impact of dragging Treasury borrowing costs higher.        

  "Depending on the media you consume, the trade negotiations are the best, or worst, policy steps the U.S has made in decades."     

According to the Richmond Fed study referenced earlier, research indicates that each 10 percent increase in tariffs generally raises producer prices by one percent and it translates to roughly a 0.3% increase in the consumer price index (CPI).  A 2019 working paper found that tariffs generated $51 billion in losses for consumers and firms that depend on imported goods, though if you factor job gains in protected industries the net loss to the economy was $7.2 billion, or 0.04% of GDP.  The conclusion of the Richmond Fed paper was that the economic effects of the 2018-2019 tariffs were a net negative for the economy.  As it related to the current tariff discussion, the paper models four separate scenarios, ranging from an Average Effective Tariff Rate (AETR) of 7.1% to 17%.  We expect this Fed study, along with the economics 101 concept of comparative advantage is the basis for both the Fed and many people to think that tariffs will result in slower growth and inflationary pressures at the same time. It wasn’t long ago when we were fearful of having to entirely rely on other countries for personal protective equipment, pharmaceuticals, and semi-conductor chips during the pandemic. Hopefully president Trump’s vision isn’t to make socks in the U.S. but that there is a view to make value-added goods like semi-conductors, cars, medical devices and pharmaceutical drugs in the U.S.  The “forgotten consumer” mentioned last quarter may get some source of utility from onshoring crucial industries.  Although many people have determined the Trump approach to trade negotiation is a major policy blunder, it continues to feel like a forgivable episode.  In other words, if there is a misstep, this feels like a situation where the Trump administration can reverse course to a degree. If, in fact, there are lopsided trade agreements, then pursuing fair or more equal terms is seemingly a defensible position.  Depending on the media you consume, the trade negotiations are the best, or worst, policy steps the U.S has made in decades.  Absent a financial institution failing due to higher yields and widening spreads or segments of the capital markets freezing, this feels like an episode that offers a retreat (with egg on our face) if needed and a possible “win” for U.S. taxpayers and workers in some strategically desirable segments of the economy.               

Prior to recent inflation data, it seemed as if the Fed would be nearly immediately in the position of having to choose between allowing inflation to run hotter than their stated goal of 2% or having to preventatively support the employment environment.  Recent inflation reports have shown an uptick and at the same time consumer sentiment is cratering and long-term inflation expectations are near a 30-year high. Although the unemployment rate moved slightly higher, to 4.1%, historically, that is essentially “full employment.”  The Fed’s “Sophie’s Choice” that is being bantered about seems to be less agonizing than the market indicates.  De-globalization and friend-shoring were going to create some inefficiencies but with that, the risk of supply shocks is diminished.  The changes and inefficiencies of using tariffs feels like it is an extension of the changing location of production, with the added benefit of continued support of full employment, economic activity, possibly the multiplier effect at work, and the benefits of research and development that accrues to the benefit of the U.S. (understanding that current efficiencies theoretically offer the ability for savings and investment that could have similar benefits).  Given the current 90-day pause of the implementation of tariffs for all countries except for China, the Fed’s most likely path is to leave policy unchanged, which is to say slightly restrictive, until employment measures deteriorate. If capital markets are functioning in an orderly way and borrowing costs remain in check, the Fed will take its direction from the labor market.  Recent CPI numbers produced a month-over-month decline that was the largest since June of 2020.  Headline CPI fell 0.1% when expectations were for an increase of 0.1% on a month-over-month basis and core CPI was up 0.1% on a month-over-month basis when expectations were for growth of 0.3%.  On a year-over-year basis, the CPI headline is growing by 2.4% and core CPI is growing at a pace of 2.8%.  Since the 25-year average 12-month CPI is 2.5% (Source: Bloomberg), we think the Fed would be prudent to maintain their slightly restrictive policy stance, given that inflation is effectively “average” and the labor market is tight by historical standards.  If cracks in market liquidity emerge, the Fed will obviously step in and change course. 

There has been a lot of consternation caused by the polarized political environment. Specifically, there has been a public debate between Republicans who say we have a spending problem, and Democrats who often say we have a “paying for” problem.  According to a report issued on May 20, 2024, from the non-partisan Tax Policy Center, in the post WWII era, revenue as a percentage of GDP has been roughly 17.18%, while average outlays as a percentage of GDP approximate 19.716%. Their estimate for 2024 was that revenue would approximate 18.0% of GDP and spending would be 24.6%. Treasury.org places the 2024 spending level as a percentage of GDP at 23%.  Relative to GDP, it feels like spending is the side of the equation that must make the largest move toward historical averages to have a more balanced budget. Coming off the needed and elective spending related to the pandemic, it makes sense that spending would need to revert to something “normal” and it is also predictable that the return to normal would be celebrated by some people and feared by others. 

"Although we don’t know the outcome of this wager, we can look to history for some similar events as a guide to how this may go."

The tariff situation has been so fluid that it is daunting to start to form an opinion about it, much less putting something on paper that won’t be in readers’ hands until the last half of April.  Just this week, Goldman Sachs made a forecast for a recession, only to retract that call on the same day.  The White House’s goals appear to be to raise revenue, support “American jobs”, and seemingly there is a goal of having fairer, or more favorable trade terms. In the end, it is a tax on consumption. Some of the burden may fall on companies that export to the U.S., retailers and purveyors may wear some of the cost, and consumers will likely bear a portion of the burden.  As a consumption tax, depending on what the final landscape looks like, it may be a regressive tax that places a comparatively large part of the cost on lower income people (from a percentage of disposable income standpoint).  Said differently, you could see it as broadening the base of taxpayers.  The Covid stimulus dollars taught us that money in the hands of lower income people is more likely to be spent than is the case for higher income earners.  By extension, the velocity of money in the hands of lower income people may be greater than it is for high income people.  The gamble that we appear to be making is that although lower income people will bear much the short-term burden, longer term their job prospects and future wages will make up for the short-term pain.  Although we don’t know the outcome of this wager, we can look to history for some similar events as a guide to how this may go.  As mentioned, tariffs are essentially a consumption tax. Japan has had three major consumption tax hikes that occurred in 1997, 2014, and 2019.  We are already hearing importers racing to fill warehouses ahead of the tariff hikes.  Not surprisingly, just ahead of the three hikes in Japan, consumption ramped up and then fell meaningfully after the tax was enacted.  It may be related to demographics or somewhat attributable to the consumption tax, but household spending in Japan still hasn’t recovered to the levels preceding the 2014 hike.  We find it interesting that comparatively, a consumption tax may be a bigger deal in the U.S.  According to Bloomberg, 69% of U.S. GDP is related to consumption, whereas only 53% of Japan’s economy is based on consumption.  Changing the dynamics of consumption in our economy seems like it will have major implications (to state the obvious).  If we borrow from the three Japanese experiences, the shortest time to recovery, where consumption returned to pre-tax-hike levels was 45 months, following the 1997 change.  Political realities suggest that we don’t have the appetite for “short-term” pain of 45 months. We interpret this to say that consumption will accelerate in the short run and fall off once the tariffs are really real this time for sure (with no changing our mind, most likely). 

It is believed that the U.S. Treasury market move caused President Trump to blink and pause the tariffs for all countries except for China.  Earlier in April, Treasury yields fell on the assumption that growth would slow and that the inflationary pressures caused by tariffs would be more of a one-time price hike, rather than a trend toward higher rates of inflation. As the risk of a global trade war increased, it may be the case that the U.S. Treasury status of being a safe haven asset was being called into question.  It may also be the case that our trading partners were looking at decreased trade activity and the need to buy Treasuries with dollar-denominated trade proceeds.  It is also possible that foreign countries were selling Treasuries in protest of the approach or content of this negotiation.  We can spin our head on the bat as well as anybody, but in the end, much of this is self-governing.  If borrowing costs get too high, financing costs will result in slowing sales activity, the housing market will slow, and decreased economic activity should depress inflation expectations.  Stagflation is something to fear, but this episode feels like it is self-inflicted and if things go too poorly, we can largely go back through the door from which we just came (meaning revert back to the old policies and changing the political landscape).  The Fed has largely ended its Quantitative Tightening program and flipping the switch to a Quantitative Easing program should be able to address shocks to the Treasury buying universe.  The Fed has several programs to inject liquidity into the financial system if needed. One thing we don’t anticipate is for the Fed to simply step in due to a general feeling of uncertainty.  A liquidity shock or eroding employment numbers are the challenges we would expect would be required for the Fed to change their policy stance in short order.                         

At the time of the writing of this piece, the U.S. 10-year Treasury yield sits at nearly 4.5%. Higher for longer seems like it will hold for much of this year, especially with the spending expectations for other safe haven sovereigns.  If 10-year Treasuries break out above 5% it would seem we will test a level between closer to 5.5% and the floor we are now forecasting is 3.5%.  We continue to think U.S. Treasury rates will depend on expectations for fiscal discipline and we expect that Treasuries will benefit from “flight to quality” events where Treasury yields fall in the face of volatility and uncertainty.  At the current time, there really isn’t any alternative.

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