A hawkish Fed reshapes the yield curve

Key takeaways

• The Fed’s unanimous rate hike surprised some investors and reinforced a hawkish tone, driving a bear-flattening move in Treasuries.
• Credit spreads remained resilient despite a heavy supply calendar, as investors favor high-quality income at attractive yields.
• We expect one additional hike before the Fed pauses, with cutting risks building in 2027. We see continued opportunity in municipals.

Market recap

The U.S. Federal Reserve took center stage, raising rates 25 basis points (bps) to 3.75%-4.00% in a unanimous decision that surprised some investors and reinforced a hawkish tone. Treasuries were volatile as the hike and oil prices, which tested recent highs near $110 before retreating, drove sentiment. The yield curve bearflattened, as the front end sold off while long rates held firmer ground following the hawkish signal. Corporate issuance remained heavy in the post-Labor Day period, though demand absorbed the supply and credit spreads stayed broadly resilient. Fixed income returns were mixed. The Bloomberg Aggregate U.S. Bond Index returned -0.03%. Investment grade corporates returned 0.13% and preferreds 0.04%, while high yield returned -0.28%.

Fixed income outlook from this week’s activity

The Fed’s 25 bps hike came with a signal for one additional increase before year-end. We view this as a closer call than markets are currently pricing in, and likely the final move before the Fed pauses. Looking to 2027, we see Fed risks tilted toward a rate cut, though uncertainty persists around oil prices, tariffs, technology spending and fiscal policy. The heavy supply calendar ahead should prove manageable given firm demand.

We forecast the 10-year Treasury yield at 4.75% for year-end 2026 and 4.50% for year-end 2027, with the 2-year at 4.50% this year and 4.00% next, implying modest curve steepening in 2027.

Credit fundamentals remain sound. We favor high-quality income, as spread sectors still offer attractive yields despite compressed risk premiums. In municipals, we favor longer duration over Treasuries and view recent cheapening as an opportunity to add quality duration.

Weekly fixed income snapshot

U.S. Treasuries

The yield curve bear-flattened as short-term rates repriced higher for further Fed tightening, while longer-term rates held steadier on the central bank’s inflation-fighting message. Treasuries traded volatile alongside oil prices, which tested recent highs before settling, and swings sharply eased once the Fed’s decision was announced.

The 2-year yield rose 12 bps to 4.75% and the 5-year 7 bps to 4.86%, while the 10-year edged up 3 bps to 5.00% and the 30-year fell -3 bps to 5.33%.

Tax-exempt municipals

Municipals underperformed the broader market as tax-loss selling and slower reinvestment demand amplified the rate move. The weakness reflected technical factors rather than credit deterioration, and renewed demand emerged late in the week as investors recognized value at higher yields. New issuance moderated but stayed elevated, lending some stability. Stable credit fundamentals and elevated yields continue to support a constructive longer-term view.

The Bloomberg Municipal Index returned -0.31%.

Taxable municipals

Taxable munis declined alongside the broader rate move, pressured by their longer-duration profile. Higher absolute yields are increasingly drawing crossover investors seeking to lock in attractive levels, providing a natural floor for the sector. We view the pullback as an opportunity to add high-quality duration.

The Bloomberg Municipal Taxable Index returned -0.07% with spreads at 51 bps.

Investment grade corporates

Spreads proved resilient, tightening even as the market absorbed a post-Labor Day supply surge and the Fed’s hike. Gains were broad-based across ratings and sectors, with technology outperforming on strong demand for high-quality paper. A busy calendar exceeding $53 billion was met with healthy oversubscription, and higher rates continue to attract yield-focused buyers. Fund flows turned negative for the first time since April.

The Bloomberg U.S. Corporate Bond Index returned +0.13% with spreads at 75 bps.

U.S. high yield corporates

High yield traded defensively for most of the week before firming Friday on the latest inflation data. Lower-rated credit outperformed higher-quality paper, suggesting the move reflected broader market sentiment rather than fundamentals. New issuance was the dominant theme, with steady deal flow drawing strong demand from institutional investors.

The Bloomberg High Yield 2% Issuer Capped Index returned -0.28% with spreads at 267 bps.

Preferred securities

Preferred securities traded choppy as volatility around the Fed decision, oil prices and fund flows drove broader swings. Additional Tier 1 (AT1) bonds were especially volatile before recovering somewhat, while domestic preferreds and hybrid securities held steadier. Bank preferreds have traded heavy on recent supply, while hybrids have firmed and outperformed. No new deals priced.

The ICE Preferred Index returned +0.04% with spreads at 150 bps.

Senior loans

Loans posted a positive return and outperformed high yield, and the sector was insulated from the rate selloff by their floating-rate structure. The primary market stayed busy, dominated by loan repricings alongside new issuance, while fund flows remained healthy. With a full pipeline still to price, we expect the technical backdrop to stay constructive into month-end.

The S&P Leveraged Loan Index returned +0.16% with spreads at 468 bps.

Securitized credit

Agency mortgage-backed securities (MBS) sold off midweek before recovering, with higher-coupon bonds leading the rebound as mortgages modestly underperformed Treasury hedges. Other securitized sectors were largely insulated from the volatility as higher yields drew strong demand. Asset-backed securities (ABS) opened the month with a robust calendar, including the tightest credit card deal of the year, while collateralized loan obligation (CLO) spreads compressed. Commercial mortgage-backed securities (CMBS) trading picked up as investors sold both investment grade and non-investment grade risk, though spreads held steady.

The Bloomberg MBS Index returned -0.05% with spreads at 34 bps. The Bloomberg CMBS Index returned -0.18% with spreads at 63 bps. The Bloomberg ABS Index returned -0.06% with spreads at 40 bps.

Global emerging markets

Emerging markets debt declined alongside the global rate move, though hard-currency sovereign spreads compressed, largely reflecting a lag rather than improving fundamentals. Retail outflows accelerated, while new issuance came slower than expected as geopolitical uncertainty kept issuers on the sidelines. The two deals that priced, both investment grade corporates, traded well in the secondary market.

The Bloomberg Global EM Index returned -0.16% with spreads at 155 bps.

U.S. Treasury market yields

Fixed income characteristics and returns