Hawkish Fed rate cut steepens Treasury curve

Weekly fixed income update highlights

• Treasuries, investment grade and high yield corporates, taxable munis, MBS and emerging markets retreated.
• Senior loans and preferred securities gained.
• Municipal bond yields remained essentially unchanged once again. New issue supply was $10.6B, and fund inflows were $16M. This week's new issuance is $6.8B.

Fixed income markets diverged last week as the U.S. Federal Reserve delivered an expected 25 basis point rate cut with hawkish policy guidance. The Treasury yield curve steepened while credit sectors retreated and municipals remained resilient.

Watchlist

• 10-year Treasury yields increased again last week and remain close to our year-end forecast.
• Spread sectors were mixed versus similar-duration Treasuries as economic data were steady.
• We expect the technical environment for municipal bonds to continue improving in 2026.

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.

Treasury curve steepens while credit markets retreat

The U.S. Treasury yield curve steepened last week, with 10-year yields rising 5 basis points (bps) to 4.19% and 2-year yields falling 4 bps to 3.52%. The Fed cut interest rates by 25 bps as expected, though the policy statement skewed hawkish. Chair Powell's press conference offered dovish counterpoints, emphasizing potential downward revisions to labor market data. Economic data also sent mixed signals: job openings ticked higher, signaling continued strength, but the quits rate fell, suggesting loosening employment conditions. We expect the labor market to soften modestly before stabilizing in 2026.

Investment grade corporates softened, returning -0.30% on the week and lagging similar-duration Treasuries by 7 bps. The selloff in longer-duration rates pressured performance, compounded by several sector-specific headwinds. AI-linked tech credits saw spread widening after disappointing earnings showed softer revenue growth and higher planned capital expenditures. Media names weakened amid M&A activity. Inflows slowed to $2.7 billion while supply remained muted at $6 billion. Year-to-date issuance now tracks 6.6% above 2024's pace.

High yield corporates also retreated, returning -0.13% and underperforming similar-duration Treasuries by 17 bps. Senior loans returned 0.13%. Lower-rated companies in the senior loan market, which stand to benefit from lower overnight rates, outperformed at 0.19%. The lowest-rated high yield segment lagged at -0.17%. Supply was robust, with $7.1 billion pricing in high yield and $22.8 billion in loans. High yield funds drew $543 million in inflows, while loan funds posted -$123 million in outflows.

Emerging markets outperformed, returning -0.04% but topping similar-duration Treasuries by 13 bps. Spreads were generally steady. Inflows slowed to $430 million but total more than $27 billion year-to-date. New issuance was quiet, with only one $180 million corporate deal pricing. 2025 supply is up nearly 70% from 2024's pace.

The muni market remains resilient through year-end

The municipal bond yield curve held steady last week. Short-term yields closed unchanged, while long-term yields rose 3 bps. New issue supply was well received, with positive fund flows including $410 million in transfers from money market funds to longer-term exchange-traded funds. This week's expected supply should be readily absorbed.

The muni market remains well bid, driven primarily by Treasury strength. However, munis have continued to outperform on their own merit. The new issue calendar should be thin through year-end due to U.S. holidays, while investor demand from both individuals and institutions remains robust. December's $42 billion in reinvestment proceeds have yet to be fully deployed, with an additional $40+ billion is expected on 01 January. We expect the muni market to remain well bid through mid-January.

The Alabama Highway Authority issued $730 million in special obligation revenue bonds (rated Aa2/AA, Assured Guaranty wrap). The deal was heavily oversubscribed except for the 2034 maturity, allowing underwriters to lower yields across most of the curve at final pricing.

High yield municipal fund flows were balanced last week, absorbing modest tax loss selling. Open-end funds posted -$200 million in outflows while exchange-traded funds drew $200 million in inflows. Reinvestment flows kept new issues well bid. Most deals were well subscribed, with some headline transactions oversubscribed by as much as 15x. The market appears well positioned to absorb any remaining tax loss selling as supply tapers and year-end reinvestment cash arrives. Brightline West bonds continue facing selling pressure post exchange.

December's $42 billion in muni reinvestment proceeds have yet to be fully deployed, with $40+ billion more expected in January.

In focus: Hawks and doves perch as the Fed cuts rates

The Federal Reserve reduced rates by 25 bps for the third consecutive meeting, lowering the target policy rate range to 3.50%-3.75%. This move, anticipated by investors, aligns with the central bank's previously published dot plot.

The Fed's policy statement leaned hawkish compared to October. Instead of referencing "additional adjustments to the target range for the federal funds rate," the statement mentioned "the extent and timing" of adjustments. That subtle shift suggests reduced confidence about cutting rates again soon.

In his press conference, Chair Jerome Powell stated that "the fed funds rate is now within a broad range of estimates of its neutral value" and that the central bank is "well positioned to wait and see how the economy evolves." Both comments point to less urgency to cut rates again. But in a nod to the doves, Powell repeated previous rhetoric about "significant downside risks" to the labor market, adding "I don't think a rate hike is anybody's base case." This indicates the Fed's next move remains biased toward easier policy.

The updated Summary of Economic Projections again showed one rate reduction next year. However, we expect two additional rate cuts (totaling 50 bps) in 2026 - 25 basis points more than our previous forecast. This revision reflects softer labor market data and the increasing odds of a more dovish chair to replace Powell in May.