The Fed delivers a hawkish hold

The U.S. Federal Reserve held rates steady today, pausing after its September hike to weigh incoming data. Resilient growth and persistent price pressures kept the Fed on hawkish footing, though it opted to wait before moving again. We expect one more hike by year-end, followed by a prolonged pause as inflation moderates.

Key takeaways

• The Fed voted to keep its target policy rate unchanged at 3.75% to 4.00% in a split 10-2 decision, following its September increase.
• The brief policy statement acknowledged the policy pause, assessing that “the accumulation of more information will help the Committee determine the policy stance appropriate to ensure a timely return to… 2% inflation goal.”
• Eight FOMC meetings per year were assessed to be the “right number,” though one meeting will focus on broad monetary policy strategy in 2027 with no vote or statement anticipated. Two such meetings in 2028 will allow for strategic thinking about “big questions.”
• Chair Warsh struck an optimistic tone on the economy, acknowledging that more work is needed to deliver price stability. But the tightening in financial conditions bought policymakers time to assess incoming data before making another move, likely in December.

What happened?

The FOMC paused in October after its September rate increase, with a divided 10-2 vote. The dissents contrast with September's unanimous decision to raise rates for the first time since 2023 and reflect uncertainty over the inflation outlook.

The brief statement described the economy as strong and domestic activity as resilient amid elevated uncertainty. It again offered no forward guidance, saying only that the current stance will ensure a "timely" return to the 2% target.

Investors expected a clear message after September's surprisingly hawkish, decisive hike. The Fed instead cited recent tightening in financial conditions and said more information will guide its policy stance. This signals another increase by year-end, but beyond that, the outlook is less clear given the Fed's data dependent approach.

In the press conference, Chair Warsh struck a constructive tone, noting the "overwhelming judgement at the FOMC is that monetary medicine is starting to work." He indicated the coming period should bring more clarity that inflation is returning to target in a timely manner.

Core inflation has surprised to the upside in recent months, and near-term price pressures could persist. Distortions from last year's government shutdown complicate the trend, likely lifting year-over-year prices in coming months and keeping a year-end hike on the table. We still expect inflation to moderate through 2027 and labor markets to stay stable or loosen slightly, easing pressure to raise rates next year. Our year-end forecast for the 10-year Treasury yield is 4.95%.

Risk assets remain a key driver of easy financial conditions, offsetting the rise in real yields, with the wealth effect supporting activity. Third quarter growth likely accelerated, though recent equity market volatility is a potential headwind. That gives the Fed time to assess before lifting rates beyond what we see as neutral.

The meeting also brought a surprise: the Fed will pursue strategic deliberations in some of its annual meetings. Eight meetings per year were judged the "right number," but one meeting in 2027 will focus on broad monetary policy strategy, with no vote or statement expected. The count rises to two strategic meetings in 2028 to address "big questions." Investors are likely left with plenty to consider after today's decision.

The Fed catches its breath

The Fed has shifted from its hawkish September stance to a wait-and-see approach, holding rates steady despite persistent price pressures. Tighter financial conditions and a softer-than-expected September jobs report contributed to the pause. The Fed will assess incoming data before its next move. Having hiked in September for the first time since 2023, it has removed the “dose of accommodation,” and we expect another increase by year-end.

Elevated energy prices, renewed geopolitical tensions and higher yields from intensifying competition for capital have complicated an otherwise encouraging inflation picture. We expect the Fed to follow through on its projected hike by year-end, but additional increases are unlikely given the risk to growth. We expect stable growth and moderating price pressures to dominate through 2027, keeping the Fed on hold, though oil, tariffs, tech spending and fiscal policy remain swing factors.

Another hike likely precedes a prolonged pause. September's hotter-than-expected core CPI and firm PPI led markets to price in a renewed hiking cycle, but there is limited evidence of a reflating economy. While commodity prices warrant watching, recent policymaker commentary signals growing uncertainty, supporting a prudent approach.

That uncertainty was reflected in today's dissents, with 2 FOMC members voting for another increase. Governor Hammack has warned of inflation risks from repeated supply shocks, and Governor Cook shares that concern. The 10-year Treasury yield's rise of only ~5 basis points (bps) since the September meeting masks sharp intra-period swings driving tighter financial conditions, and several policymakers noted the central bank has flexibility and can take time to assess the economy before acting.

We don't think the data justifies the additional hikes markets are pricing in through year-end 2027. Further out, we still see risks skewed toward a prolonged pause, though oil, tariffs, tech spending and fiscal policy remain swing factors.

Escalating U.S./Iran tensions have pushed oil and gas prices sharply higher and could decide whether another hike comes this year. Crude has risen from $101 to $115 since the last Fed meeting, while diesel has remained close to $6.30/gallon. Despite the near-term upside pressures, we believe inflation will resume a moderating path through 2027 as tariff pass-through fades, shelter costs cool, and earlier AI-led price pressures ease. We forecast core PCE at 3.0% by year-end and 2.5% in 2027.

Today's pause is largely about taking stock. Chair Warsh has signaled the Fed will defend price stability, and even with financial conditions assessed to still be accommodative, policymakers are taking a prudent approach in pausing. Incoming data will determine the direction of the policy path. The hawkish tone keeps optionality to raise rates again, but not so hawkish as to justify the hiking cycle markets anticipate.

A stabilizing labor market gives the Fed more room to focus on inflation. September payrolls slowed to 29,000 from a revised 133,000 in August, but still trend above the 45,000 average pace of the past year. Unemployment edged up to 4.2% as participation rose, while wage growth slowed to 0.1% month-over-month and 3.0% year-over-year, consistent with the Fed's 2% target. We read this as stabilization rather than reacceleration and expect a low-hiring, low-firing dynamic with steady unemployment next year.

The Fed's September projections called for 2.3% GDP growth and 3.4% core PCE in 2026, reflecting solid growth alongside a temporary inflation shock. Core PCE is expected to fall to 2.5% in 2027 as that shock fades, and the updated projections reinforce the picture outlined in June.

We see the fed funds rate near neutral, limiting further moves. Energy risks warrant watching, and upward pressure on yields may persist from fiscal concerns and heavy AI-related issuance. Absent a negative growth shock, we remain cautious on extending duration and favor income opportunities in shorter-to-medium maturities. We now forecast the 10-year Treasury yield at 4.95% by year-end and 4.75% by end-2027.

What does this mean for investors?

Economic growth has remained resilient despite elevated uncertainty, rising yields and geopolitical tensions. In this environment, we see room to add credit exposure, though selectively, given still-stretched valuations. Strong earnings support a modest risk-on posture, but the S&P 500's forward P/E sits above its long-run average, and analysts forecast double-digit EPS growth, more than triple the 7.5% long-run average. Investment grade spreads near 90 bps have been tighter than current levels only 4% of the time over the past 25 years, per Bloomberg.

Rather than abandon risk, we see an opportunity to reconcile a positive economic outlook with rich valuations by looking deeper into the fixed income universe. Expanding that opportunity set does not require moving lower in credit quality. Instead, we believe the best ideas lie in lesser-known credit segments where investors are rewarded for navigating complexity.

Securitized credit offers a compelling yield profile with lower rate sensitivity than traditional bonds. Commercial mortgage-backed securities (CMBS), asset-backed securities (ABS) and collateralized loan obligations (CLOs) can yield more than traditional investment grade corporate bonds, while carrying a shorter duration, a valuable trait as rates remain volatile.

Esoteric ABS, backed by non-traditional collateral such as data centers and aircraft and railcar leases, has offered consistently higher yields than equivalently rated corporates. CLOs, a floating-rate asset class with near-zero duration of about 0.25 years, have low correlation to most traditional fixed income sectors and have historically posted far lower default rates than corporate bonds.

Within the broader market, we also see selective opportunities in preferred securities, leveraged loans and certain emerging markets economies with strong fundamentals or exposure to higher oil prices.

Listed infrastructure looks attractive. The AI boom needs power, and power needs regulated infrastructure to generate and transmit it. Data centers can be built in 12 to 36 months, while transmission upgrades and new generation capacity take far longer. That mismatch may create durable scarcity value and earnings potential for utilities able to deliver capacity ahead of demand.

As equity portfolios become increasingly concentrated in the AI trade, listed infrastructure may offer a compelling complement. It provides exposure to the digital economy through physical assets that are largely insulated from the technology they support. Recently, the correlation between infrastructure and technology has turned negative, which has strengthened the defensive diversification benefit.

Preferred securities stand out amid the rate volatility weighing on broader fixed income. Spreads have tightened in both $1,000-par and contingent capital (CoCo) segments, helping drive outperformance versus most U.S. investment grade sectors this year.

Preferred issuers look fundamentally strong. About 80% of preferred securities come from banks, insurers and utilities — heavily regulated sectors showing sound fundamentals. Technicals also support the asset class. European Additional Tier 1 (AT1) CoCo issuers have front-loaded supply, with roughly 80% of full year volume already issued and well absorbed, and supply should moderate. Demand remains strong for the tax-advantaged qualified dividend income (QDI) that certain preferred structures offer, while hybrid preferreds remain eligible for corporate bond index inclusion.

Opportunities also exist beyond traditional credit. We favor an integrated approach combining convertible arbitrage, long-short credit and opportunistic CLO investing, strategically allocated within a single framework.

Convertible arbitrage anchors this approach. Convertible bonds’ embedded optionality means they can benefit from volatility, potentially improving returns when traditional strategies struggle. The global convertible market has grown to $600 billion, with liquidity at record levels, offering a deep and diverse opportunity set.

Long-short credit adds flexibility. By taking both long and short positions across high-yield bonds and senior loans, including distressed situations and tactical hedges, this component seeks alpha while actively managing downside, a dynamic tool for navigating cyclical turns rather than a passive bet on spreads.

Opportunistic CLO debt and equity investing completes the framework. High-conviction positions in structured credit, deployed selectively when valuations compel, can offer a differentiated return stream with low correlation to the other two strategies, which may enhance diversification.

Together, we believe these three strategies aim to navigate different market environments, with the potential for attractive risk-adjusted returns, enhanced resilience during market downturns, and additional diversification relative to both equities and traditional credit. Investors who incorporate this multi-strategy approach may be better prepared to respond to evolving market conditions.