Bond markets split on Fed policy uncertainty

Weekly fixed income update highlights

• Treasuries were flat for the week.
• Mortgages, municipals and emerging markets advanced, while investment grade and high yield corporates, preferreds and senior loans retreated.
• Municipal bond yields were essentially unchanged. New issue supply totaled $3.8B, and fund inflows were $2.1B. This week's new issuance is $7.2B.

Fixed income markets diverged as the U.S. Federal Reserve held rates steady. Treasury curves steepened on the Warsh Fed Chair nomination, while investment grade and high yield corporates retreated amid heavy supply. Emerging markets outperformed. Municipal bonds held steady on strong demand and reinvestment flows.

Watchlist

• 10-year Treasury yields increased slightly last week, and we expect a modest rally from current levels.
• Spread sectors were mixed versus similar-duration Treasuries ahead of this week's jobs data.
• We believe 2026 presents favorable market dynamics for municipal bonds.

Investment views

We believe fixed income yields generally present a very attractive entry point, creating compelling income opportunities.

Downside economic risks are material, despite strong fundamentals, with tariffs likely to compress consumer spending and weigh on business fixed investment. But a U.S. recession is not our base case.

Risk premiums may widen further, with entry points likely to become more attractive over the coming quarters. Duration is likely to reassume its role as a growth hedge.

Key risks

• Tariffs further undermine consumer and business confidence, raising prices while weighing on sentiment and activity.
• Inflation fails to continue moderating as expected, weighing on asset prices.
• Geopolitical flare-ups intensify around the world.

Investment grade corporates lag amid supply surge

The U.S. Treasury curve steepened last week, with 2-year yields falling -7 basis points (bps) while 10-year yields rose 1 bp and 30-year yields rose 5 bps. Two parallel monetary policy developments drove those moves. First, the Fed kept rates steady, and Chair Powell leaned slightly hawkish in his press conference. Second, and more impactful, President Trump nominated Kevin Warsh for Fed Chair. Warsh has previously criticized the Fed's asset purchase programs, signaling potential unwillingness to maintain a large balance sheet. This could pressure long-end yields higher.

Investment grade corporates retreated, returning -0.11% and lagging similar-duration Treasuries by 9 bps. Spreads widened slightly, though technicals remain highly supportive. The asset class enjoyed $11 billion in inflows, the largest since last August. Supply remained robust at over $37 billion, bringing January's total above $200 billion - 18% above 2025's pace. Despite heavy issuance, demand remains very strong, with average oversubscription rates of 4x and new issue concessions below 1 bp.

High yield corporates weakened, returning -0.16% and underperforming similar-duration Treasuries by 33 bps. Senior loans returned -0.55%, the worst weekly performance since last April's tariff announcements. Loan weakness concentrated in the software sector (12% of the index) as trading increasingly reflects AI-driven disruption risks. Around two-thirds of the loan market now trades above par, down from 78% two weeks ago. Despite volatility, high yield and senior loan funds enjoyed inflows of $233 million and $234 million, respectively.

Emerging markets outperformed again, returning 0.09% and beating similar-duration Treasuries by 6 bps. Spreads were flat across both sovereigns and corporates. Inflows accelerated to $3.5 billion while supply slowed to $18 billion, met with solid demand averaging 4.5x oversubscription.

Light supply and strong flows support municipal bonds

Municipal bond yields ended last week essentially unchanged, with short-term yields declining -3 bps while long-term yields held steady. Light new issue supply was well received, and fund inflows remained robust, including $1.4 billion into exchange-traded funds. This week's undersized new issuance should also be well received.

The muni market remains well bid for several reasons. The government bond market is stable, and outsized reinvestment flows continue - $47 billion arrives 01 February and $32 billion on 01 March. While new issue supply is expected to reach $600 billion in 2026, the calendar has remained manageable so far this year relative to available reinvestment dollars. We expect munis to remain well bid for the foreseeable future.

The Florida Development Finance Corporation (Tampa General Hospital) issued $389 million in revenue bonds (rated A-). The account is closed, and the underwriter is quoting bids 1 bps cheaper than the original issue levels for both term bonds.

High yield municipal fund inflows accelerated last week, with investors adding $486 million. Many new issues were firmly oversubscribed and upsized. Secondary market demand is broadening, with focus on charter school and senior living bonds that have lagged. This week brings nine deals totaling $775 million as cash balances strengthen with 01 February reinvestment flows. Record reinvestment flows and accelerating fund flows position February for a strong start following solid January performance.

The nomination of Kevin Warsh for Fed Chair could pressure long Treasury yields higher.

In focus: The Fed's lack of surprises comes as no surprise

As expected, the Federal Reserve held interest rates steady (3.50%-3.75%) at its 2026 kickoff meeting after three consecutive rate reductions to end 2025. The decision wasn't unanimous, though, as Fed Governors Waller and Miran dissented in favor of a 25 basis point (bps) rate cut.

The policy statement leaned hawkish compared to December, with the central bank noting that the unemployment rate "has shown some signs of stabilization," while removing a reference to "downside risks to employment." The statement also described recent economic growth as "solid" rather than "moderate."

In his press conference, Chair Jay Powell avoided signaling a clear near-term policy path, saying the Fed is "well-positioned to determine the extent and timing of additional adjustments." He also indicated that inflation's trajectory will dictate future cuts, suggesting that declining inflation would "tell us that we can loosen policy." As for potential rate hikes, Powell stated, "We don't take things off the table, but it isn't anybody's base case right now."

Looking ahead, the Fed's most recent dot plot of rate forecasts showed just one 25 bps cut this year. We continue to expect two rate reductions (totaling 50 bps) in 2026. This outlook reflects our macroeconomic forecast for moderating inflation later in the year, labor market stabilization and a more dovish stance from new Fed appointees.