Jessica Schmitt (00:04)
Welcome to Understanding Edge, where we explore the trends, challenges, and opportunities shaping the fixed income markets. I'm your host, Jessica Schmitt, Director of Investment Communications, and today we're diving into the latest developments from the Federal Reserve, recent tariff turbulence, the evolving shape of the yield curve, and key risks and opportunities for fixed income investors.
Joining me is Stephen Caldwell, senior portfolio specialist here at SJF, and author of our monthly fixed income market commentary. Doug helps us decode complex macro events, and today we'll unpack what the past few months have meant for investors as we head into the second half of 2025.
Whether you're a longtime listener or tuning in for the first time, we hope you gain perspective and practical insights. Grab your coffee or tea and let's jump in.
Hello Doug. Welcome back to the podcast.
Stephen Caldwell (01:05)
Thanks, Jess. As always, it is a pleasure to be here.
Jessica Schmitt (01:09)
Well, Doug, the FOMC just wrapped its June 18th meeting. Today is June 18th, and the Fed has in prior meetings, continued to emphasize its data-dependent stance and has noted increased uncertainty, obviously tied to trade policy. Can you start us off by walking us through the latest messaging from Jerome Powell today and how fixed income markets are interpreting the Fed's posture, particularly as inflation risks and labor market dynamics continue to evolve?
Stephen Caldwell (01:46)
Yes, it looks like it's more of the same — patience and uncertainty rule the day as concerns about the eventual impact of tariffs on inflation and a slowing but still growing labor market continue to keep the Federal Reserve on the sidelines.
So, with a rather benign meeting, once again, the focus — right or wrong — is going to shift to the updated quarterly Statement of Economic Projections, which includes what is commonly referred to as the dot plot, which is a collection of the FOMC members’ predictions for future action from the Fed.
Since its introduction in 2012, market participants sometimes view the dot plot as kind of a commitment, like this is what the Fed is going to do. While the Fed members know that it's not part of any kind of agreed-upon plan, it's just their thoughts at that moment. So, Powell has indicated that potential refinement to Fed communications could be on the horizon, which could include a revision or retirement of the dot plot.
Now that's just thoughts. There's no concrete evidence about that, but that's one of the things that's been kind of thrown around. I think Minneapolis Fed President Neel Kashkari summed it up quite well when he said, I'm going to quote him here, I want to make sure I get it right, “You’re having to make, essentially, forecasts that people take very seriously, and you can’t communicate just how uncertain you really are, because you have to put these handful of dots down.”
So, what did the dot plot tell us today? It was another close call between two cuts and one cut by the end of the year. Nine participants saw one or no cuts by year end while the remaining 10 members were targeting two or three cuts, keeping the overall expectation to two cuts by really the narrowest of margins. It's interesting to note that 7 out of the 19 members now anticipate zero cuts this year, so less than half, but a pretty significant number. The Fed fund futures reflected agreement with the Fed itself, pricing in two rate cuts by year-end soon after the news was announced, and I checked it before I came in here, and it's still right around two.
So, Jess, we talked about this last episode. The Fed's mandate remains focused on keeping a lid on inflation and keeping the labor market strong. Inflation is still above the targeted level of 2% and the labor market continues to cool, putting the Fed in a pretty challenging position to control an inflation rate that is above targeted levels and could potentially rise due to the impact of tariffs and geopolitical risks. Historically, the Fed would raise rates to slow things down, but to boost a flagging labor market, the Fed would lower rates to encourage company spending and hiring.
The situation really hasn't changed over the past several weeks as the labor market added 126,000 jobs in May, but revisions to prior months resulted in pretty significantly lower levels than what was originally reported. The unemployment rate has remained steadfast at 4.2% for the past three months.
You could say that the labor market has kind of reached an equilibrium. Companies aren't hiring as much, but they also aren't firing as much. So we're stuck in kind of this malaise of slow growth, but nothing overly exciting. On the inflation side, it feels like we're in this waiting game. Most of the market is operating under the impression that tariffs will be inflationary, but we haven't seen it yet in the official numbers. Part of this is due to timing. Companies attempted to front-run the tariff announcement by ordering ahead of Liberation Day, avoiding the pending tariffs, but they're going to have to rebuild inventory at some point, and that's when we could start to see the impact of tariffs.
The other part of it is the impact of tariffs takes time, but upcoming data could begin to reflect the impact as companies like Walmart have communicated quite clearly that they might not have a choice and will pass along some of the impact of tariffs. But a big component of the inflation equation is expectations. There are surveys that go out and attempt to interpret how consumers and businesses think about inflation, but the opinions are just that, they're opinions, and they're not hard fact.
It's the actions of the various components of the market that can potentially determine the future path of inflation. And here's what I mean by that. If a business expects an increase in costs in the coming days or weeks for something, say, I don't know, like tariffs, there's a good chance that they'll raise prices now to get ahead of that upcoming change. And if the consumer is concerned about the potential increase in living expenses, they're going to push for an increase in wages and/or cut back on some of their discretionary spending.
We look at some of those surveys in the University of Michigan consumer survey for the one-year forward inflation, and the 5-to-10-year forward inflation came in at 5.1% and 4.1%, respectively. Now those are both down from the prior month, but they're still well ahead of the current levels and the targeted level of 2%. So will these expectations prove prescient and result in inflation with consumers adjusting their spending behavior? We're just going to have to wait and see.
Jessica Schmitt (07:14)
Okay. Well, a lot has transpired since the last time you and I spoke on one of the podcasts. So, let's go back to Liberation Day, which was April 2nd, and your most recent monthly commentary, which is available online, outlines the sharp market reaction that we all felt and saw, not just in equities but across credit and structured products. What surprised you the most about how the markets responded, and what should investors take away from the volatility that followed?
Stephen Caldwell (07:48)
I guess I can't say that I'm really surprised at how the markets reacted. The markets, as we know, don't like uncertainty and the wide-ranging tariffs that were announced were about as uncertain as you can get. Maybe the biggest surprise was how dramatically markets shifted without really knowing what was going on and what the end game would be for global trade and the hits and the uncertainty just kept coming as the administration walked some of the tariffs back, changed up the timeline on others, and then, most importantly, got into a game of chicken with China, resulting in escalating tariffs between the two countries before eventually cooler heads prevailed. And even though I'm here to talk about fixed income, which I'll cover, let's consider the movement of the S&P 500. The S&P 500 started the month of April at 5,664. It dropped as low as 4,835 on an intraday basis on April 7th, but it finished the month at nearly 6,000, so the return over the two-month timeframe is 5.6%, which is pretty good.
Remember, sometimes it's more about that destination than it is about the journey itself, and it was a pretty chaotic journey. On the fixed income side, it was a similar story with spread levels gapping wider in April before finishing at nearly the same level or even tighter by the end of May — depending on the sector. Both investment grade and high yield spread levels ended up lower by May month end, despite a level of widening that we hadn't seen really since the yen carry trade unwind in August of last year.
There was a similar pattern in the securitized markets with index-eligible non-agency commercial mortgage-backed securities and asset-backed securities on a bit of a roller coaster, only to close out May at pretty much the same level as they were at the end of March. The one exception in the securitized sector was the agency mortgage-backed securities market, but the wider spread levels there were more closely tied to the shift higher in the longer end of the curve than anything else.
The yield curve finished Liberation Day inspired volatility in a steeper position as the two-year yield finished May at nearly the same level as it was at the end of March, though there was quite a bit of action as I was talking about during the period while the 10-year treasury yield pushed higher to finish May at 4.4%, but I'm not going to go too deep into the curve. I know that we're going to be discussing it in just a little bit.
Jessica Schmitt (10:27)
Doug, do you think that we've seen the peak of tariff-related market impact, or do you think this is just a pause in the broader landscape?
Stephen Caldwell (10:39)
While these past few months might be viewed as what could be the peak of tariff-related market volatility, I'm sure there's more to come as we get closer to various deadlines that are tied to both Europe and China. We basically bought time, but we don't have any kind of final resolution, and we won't for a while.
So, while it might not be as dramatic as what we've already experienced, because that was really fueled by the unknown, we had no idea what was going to happen. Now we've got maybe a little bit better of an idea. Any and all updates to the trade war will most likely continue to weigh on the markets, possibly good, possibly bad. As to the broader political tension, we've got two major wars going on right now with the Ukraine-Russia conflict continuing to drag out while the Israel-Iran conflict threatens to expand to a wider Middle East conflagration. I think the markets have become fairly numb, unfortunately, regarding the Ukraine-Russia conflict. Though Ukraine’s surprising assault on Russian Air Force assets was applauded, the Israel-Iran conflict threatens to engulf the region and potentially drag in the United States, which could be yet another source of market volatility, and we've seen some that just in the last couple of days with some flight to quality as the US is saber rattling and then stepping back and the back and forth. The ongoing increase in oil prices, if the conflict escalates, could also greatly impact inflation as well.
Jessica Schmitt (12:15)
Next came the One Big Beautiful Bill, the mix of tax cuts and spending increases, and then, of course, that was followed quickly by Moody's downgrade of United States’ debt. What are some of the fiscal concerns that are associated with this bill, and how meaningful is the Moody's downgrade in the context of the broader credit market?
Stephen Caldwell (12:42)
Well, the bill passed through the House of Representatives fairly easily. It's met significant resistance in the Senate, and expectations are that passage in its original form is pretty slim. There will be some adjustments, but what those adjustments could yet be will eventually be determined. It's a big wait and see. The biggest concern is that this bill does nothing to address ongoing fiscal concerns, especially the US debt load becoming essentially unmanageable.
According to the nonpartisan Congressional Budget Office, the impact of the Bill's passage would be an increase in the deficit of $1.7 trillion over the next five years and an increase of $2.4 trillion over the next 10 years — and consider that the US is already spending more on interest payments on the national debt, roughly $1 trillion over last year, than on national defense.
You can see why Moody's finally stepped up to the plate, if you will. They downgraded US debt from AAA to Aa1 on May 16th, which brings them into line with S&P and Fitch, who were well ahead of them in downgrading US debt. S&P was well ahead of the curve. I think a direct quote from Moody's sums up their thoughts rather succinctly: “Successive US administrations and Congress have failed to agree on measures to reverse the trend of large annual fiscal deficits and growing interest costs. We do not believe that material multi-year reductions in mandatory spending and deficits will result from current fiscal proposals under consideration. Over the next decade, we expect larger deficits as entitlement spending rises while government revenue remains broadly flat.”
While it's elegant and direct, these comments are really nothing new to the market or to the holders of US debt. So what does Moody's action mean for the markets? While some volatility in spreads is always a possibility, both investment-grade corporate and high-yield corporate spreads really didn't react much to the news. In fact, spreads for these parts of the market continued to grind tighter.
As we talked about earlier, from the date of the downgrade to the end of the month, the securitized market followed a similar trajectory, barely really even phased by the downgrade. The bigger concern for the broader markets is the potential impact of higher treasury yields because higher risk must pay higher yields to entice investors on things like mortgage rates, auto loans, and other consumer financing mechanisms. It should be noted that the 10-year treasury is lower since the downgrade announcement from 4.48 to 4.39 yesterday, with the 30-year treasury following a similar path lower.
Jessica Schmitt (15:40)
And Doug, you mentioned that the markets didn't necessarily react that much to the downgrade this time. What do you think that says about investor sentiment or fatigue towards these fiscal headline risks?
Stephen Caldwell (15:54)
Yeah, it's a good way of putting it. There is some level of fatigue tied to fiscal headlines, but the market reaction really felt more like, well, it's about time than anything else. As I mentioned, S&P was the first to downgrade. They downgraded US debt almost 15 years ago for the very same reasons that Moody's cited. Things really haven't changed much, sad to say, they've actually gotten worse. Fitch joined S&P in 2023, so it really just felt like a matter of time before Moody's followed suit.
But the point remains that even though the US debt has now gone from AAA to AA+, it is still viewed as the safest investment out there. We continue to see interest from international entities, whether it's sovereigns or banks, so it still remains the stalwart fixed income security, most liquid that it's always been, and I think the reaction 15 years ago was pretty significant. I remember that. Whereas now this was kind of like, as I said, it was everyone saying, yeah, it took you long enough to get there, and frankly, when I look back at it, I'm not really sure why they waited that long. I felt the same way in 2023 when Fitch downgraded, but to each their own. But now we're at a point where the US has AA+. Does that change things? I don't think it really does.
Jessica Schmitt (17:28)
Well, let's talk about the yield curve. You mentioned in your commentary that after nearly 800 days of inversion, the yield curve has finally normalized, and historically, curve inversions have signaled recessions, but you make a compelling case in this month's commentary that maybe this time might be different. Can you expand on what makes this cycle unique, in your opinion, and whether the predictive power of the curve could be fading?
Stephen Caldwell (18:01)
Yeah, so let's start with the basics. The basics of the interest rate yield curve are pretty straightforward: to entice investors to part with their money for longer periods of time, longer maturities have higher yields, pretty straightforward.
An inversion of the curve occurs when the difference between the yield for a longer-dated security drops below that of a shorter security. In this instance, the yield in the 10-year Treasury and the 2-year Treasury. This most recent inversion of the yield curve began in July of 2022 when the yield on the 2-year treasury reached 2.97% and the yield on the 10-year treasury reached 2.93%, and as you mentioned, Jess, nearly 800 days later in September of 2024, the relationship between the two bellwether securities reverted to a more normal posture. This marked the longest period of inversion in history, outpacing the prior 623-day record from August of 1978 to May of 1980.
So, as you mentioned in your question, yield curve inversions historically have preceded recessions. Since 1980, the four major recessions that have been experienced have been preceded by inversions of the yield curve, with the recession occurring shortly after the relationship between short and long-term rates normalize. I don't include in that four major recessions the incredible short-term recession that we hit in the early days of COVID, just because it was such a unique situation.
But does this mean that a recession is imminent? Well, curve inversion has been an indicator in the past. One could argue that this time is indeed different, which I know we hate saying, but maybe it is different. Prior periods of inversion resulted in a contraction of bank profitability as high short-term rates that are paid to depositors clashed with lower long-term lending rates, and lending tended to dry up as a result.
Coming out of COVID, long-term rates climbed and even though the curve was inverted from mid-2022 to September of 2024, banks did well outside of the very short-lived regional bank crisis, and the reason being is that there was no need to raise short-term rates on interest paid to depositors as the banks were full of cash from stimulus fueled depositors. Even as short-term rates climbed, banks didn't need to adjust the rate paid to depositors since the competition for new deposits was suppressed.
So, has the yield curve inversion lost its predictive ability? It's hard to say, and we won't know for several months, if not years. Maybe a hundred years from now, we’ll look back and see this most recent inversion as the only time that a yield curve inversion did not predate a recession.
The timeframe from prior inversions to the National Bureau of Economic Research’s identification of a recession has varied quite a bit. The 1989 to 1990 recession started 267 days after the end of inversion. The 2000 to 2001 recession was 123 days after the end of inversion, and the 2007 to 2008 recession was 256 days post-normalization. As of the end of May, we are 266 days removed from curve inversion, and the economy is still chugging along. The question now becomes, is this time truly different, and have we avoided a recession despite this curve inversion, or does the length of the inversion itself expand the timeframe before we hit recession? And really only time will tell, Jess.
Jessica Schmitt (21:56)
Okay, well, as we approach the end of the second quarter and turn the page to the second half of 2025, what should be top of mind for fixed income investors? Are there sectors or strategies that you and the fixed income team here at SJF believe are well-positioned as we expect probably more volatility and uncertainty as these policies continue to evolve and growth either persists or slows down?
Stephen Caldwell (22:30)
I don't know about you or the listeners, but I think it is amazing to think that we are essentially halfway through 2025 already. These past five months feel closer to five years, given everything that's gone on in the markets and the world.
There's a plethora of things on the minds of fixed income investors, ranging from the outlook for spread levels through the end of the year to potential Fed action before year-end to shifts in the yield curve. As I mentioned previously, investment-grade and high-yield corporate spread levels are once again well below historic averages. So there are concerns around the potential impact of any spread widening there. In the securitized market, while spread levels have reverted to roughly where they were prior to Liberation Day, they're still offering better relative value to corporate debt and even better relative value looking beyond index-eligible securitized sectors.
I do believe that the Fed remains front and center in the minds of investors, given the influence that they have on the markets, as well as the expected change at the top of the house with Powell's term expiring in February of next year. Everyone's looking to see what little bit of a news feed or a quote can be interpreted to mean that, okay, they're ready to start easing the future path of rates, taking into account possible inflation increases and potential ease in the labor market strength still remains the main focus of the market, given the implications of any shift in policy.
I would say that if investors have learned one thing from what we have experienced, really since Liberation Day, it is that we must remain focused on the longer term and try to blunt the noise of day-to-day uncertainty that arises from these outside forces. While it can be unsettling, investors who remain calm and focused during periods of volatility, even the extreme volatility that we've seen, can benefit greatly from a cool demeanor, taking advantage of various dislocations in the market.
Jessica Schmitt (24:42)
Absolutely. Well, Doug, that's all I have for you today. Thank you again for joining us and sharing your insights. It's always great to get your perspective on how to navigate this ever-evolving market, so we really appreciate you being here.
Stephen Caldwell (24:58)
Well, thanks for having me. As always, I appreciate being here.
Jessica Schmitt (25:03)
And thank you to our listeners. Doug and I will return in August to unpack the future market developments that are ahead and provide an outlook as we head into fall. You can read Doug's full commentary and other fixed income perspectives on our website, www.silvercrestjefferson.com. Until then, stay informed and stay focused.