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Markets finished the 2^nd quarter in a pretty good mood.  Interest rates on short to intermediate bonds fell slightly and longer-term rates rose slightly.  Equities posted very solid gains despite a sharp decline in April as tariff uncertainty roiled equity markets.  Although GDP fell slightly in Q1, the current expectation for Q2 is close to 2.5%.  Recession fears have largely abated although a slowdown is expected in the second half of this year.  Inflation has moderated recently, but the consensus is for slightly higher inflation later this year. Expectations are for two rate cuts of 25 basis points prior to the end of the year but this is a moving target subject to numerous changes.  Tariff volatility has decreased the past couple of months but could reignite at any time.  All in all, it was a good quarter for financial assets.   

Positive news on inflation was offset by tariff uncertainty and related rhetoric from the Fed Chairman.  Three-month treasury bill yields were unchanged, the 5-year yield fell 15 basis points and the yield on the long bond increased 20 basis points.  Most bond indices posted positive returns for the quarter.  Equity markets were very volatile.  The S&P 500 fell 20% or 1,200 points after tariffs were announced but ended the quarter 5.5% higher.  It was a remarkable turnaround.  NASDAQ also had a significant sell-off and it too closed 5.5% higher for the quarter.        

As we look ahead, we still have a few serious issues that are unresolved: tariffs, global conflicts, and the outlook for inflation are a few of the most important.  Tariff uncertainty results in a very difficult operating environment for business.  Major investments won’t go forward in a world where costs are unknown.  The result should be less economic activity and lower GDP. The United States should not be subject to higher tariffs that our trading partners do not have to pay but there are many ways to resolve the issue.  What happens with Iran is anybody’s guess.  They seem to have been crippled by the fight with Israel but it’s difficult to ascertain.  The longer we go with no retaliation on their part the better.  An attack on the U.S. would have severe short-term consequences for markets but the longer term would be a bit less certain.  The outlook for higher inflation is attributable to potentially higher tariffs.  Higher inflation could take rate cuts off the table.  It seems to us that the best way to get the Fed to lower rates is to keep tariffs as low as possible. Hopefully market expectations for higher inflation in the second half will prove to be inaccurate. 

This doesn’t seem like a good environment in which to take much risk.  A more conservative approach seems to be a more prudent strategy especially when you consider our theme of extending duration in the past as rates have risen to attractive levels.  There is also a growing chorus of forecasters expecting a slowdown in the second half of the year.  In this environment corporate credit spreads should widen, which may cause the market value to fall.  We will have a more conservative bias in the near term.

"We prefer MBS trading at a discount due to the fact mortgages can prepay and the principal gets returned to the investor at $100."

Agency-backed mortgage-backed securities (MBS) offer a very liquid option, very limited credit risk, and an attractive yield.  Market prices vary depending on the coupon and maturity chosen.  We prefer MBS trading at a discount due to the fact mortgages can prepay and the principal gets returned to the investor at $100.  Let’s look at an MBS issued 5 years ago, containing 15-year mortgages and a 3.50% coupon.  The bond is offered at a price of $96.5, has a yield of 4.48%, with an average life of 3.95 years.  The spread to a like-term Treasury note is 55 basis points.  If interest rates fall and the mortgages begin to refinance and pay off early, the yield will increase to 4.69% and the average life will decline to 3.20 years.  This security performs very well if rates don’t change much and performs exceptionally well if rates decline.  It’s conservative and in this market that’s why we like it.

We also like 20-year MBS with a low coupon.  The 2.5% coupon MBS issued 5 years ago are priced around $87.25, have a 6.70 average life and a yield of 4.90%.  As we noted above, all mortgages that refinance get returned to the investor at $100.  If refinancings increase due to lower rates, the yield on this type of bond will see an improvement to 5.25% and the average life will shorten to 5.75 years.  It’s a very good option if your outlook for interest rates is lower.  This structure of MBS has no credit risk, excellent liquidity, and a historically attractive yield.  While we are generally big proponents of corporate bonds, when we compare this investment to corporate bonds rated A1 or AA, the yield the MBS offer is more appealing without taking on credit risk. 

For those readers that have not extended the maturity of their portfolio and believe we are headed for a slowdown or mild recession, it may be a very good time to add some longer maturity treasuries.  Interest rates are at historically high levels and if the economy slows the Fed will cut rates.  Bond prices move in the opposite direction rates move.  Lower rates cause bond prices to rise.  Longer maturity bonds could see a greater change in market value than shorter maturity ones.  This idea pertains to those with a specific rate outlook and a desire to increase the average maturity of their portfolio. 

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 facts 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. 

"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."

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 or more sustainable 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.       

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%.  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 also 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 to 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.         

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 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 the city of Chicago as an example of what not to do.  Roughly half of their tax receipts go to servicing debt and retirement benefits.  As of 2024, the federal government is 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, but real rates are historically high, which has typically been a good time to “go long.”  This time could be different but with 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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