Fed rate cut drives Treasury curve steepening

Weekly fixed income update highlights

• Preferreds, high yield corporates, senior loans and CLOs gained last week.
• Treasuries, investment grade corporates, MBS, taxable municipals, and emerging markets posted negative total return.
• Municipal bond yields were essentially unchanged. New issue supply was $5B, and fund inflows were $1B. This week's new issuance is outsized at $15.7B.

The U.S. Federal Reserve delivered a 25 basis point "risk management cut" last week, steepening the U.S. Treasury curve. Corporate credit markets showed resilience with investment-grade spreads hitting multi-decade lows, high yield rallying strongly, and municipal bonds maintaining attractive tax-exempt yields amid supportive technicals.

Watchlist

• 10-year Treasury yields increased slightly last week.
• Spread sectors outperformed similar-duration Treasuries.
• We expect the technical environment for municipal bonds to improve over the remainder of the year.

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.

High yield and preferred securities rally

The U.S. Treasury yield curve steepened last week, as yields on maturities of 1 year or less declined while yields on all other maturities rose. 2-year yields rose 2 basis points (bps) to 3.57% while 10-year yields rose 6 bps to 4.13%. The Federal Reserve cut the fed funds rate by 25 bps on Wednesday to a range of 4.00% - 4.25%. The cut was characterized as a "risk management cut" that addressed recent weakness in the labor market. An updated dot plot of expectations showed that the Fed is forecasting two additional 25 bps cuts are anticipated in 2025. Meanwhile, the Bank of England held its policy rate at 4% at its meeting on Wednesday.

Investment grade corporates declined modestly, returning -0.13% for the week, but outperformed similar-duration Treasuries by 18 bps. Credit spreads tightened further to 72 basis points, reaching multi-decade lows. This strong relative performance occurred despite continued deceleration in fund inflows, which totaled $3.7 billion-well below the four-week average of $6.9 billion. New issuance totaled $33.6 billion, slightly below the $35 billion forecast. Primary market conditions remained robust, with deals averaging 5x oversubscription and minimal new issue concessions. Meanwhile, preferred securities delivered the week's strongest performance, gaining 0.37% and outpacing similar-duration Treasuries by 59 basis points.

High yield corporates rallied, returning 0.34% and outperforming similar-duration Treasuries by 36 bps. Senior loans returned 0.08%. Issuance was healthy for both sectors, with just under $10 billion pricing in high yield and $14 billion in loans. Inflows were positive, with $940 million flowing into high yields funds and $125 million into loan funds.

Emerging markets declined, returning -0.34% and underperforming similar-duration Treasuries by 9 bps. Sovereign spreads decompressed as investment grade spreads declined while high yield spreads widened. However, spreads tightened for both investment grade and high yield emerging markets corporates. Inflows were solid, totaling $869 million, skewed toward hard currency funds. Supply was quiet at $16 billion, most of which came from a $13 billion multi-tranche deal from Mexico.

Muni market offers attractive yields and strong technicals

The municipal yield curve was essentially unchanged last week, with short-term rates rising 2 bps and long-term rates declining 1 bps. New issuance met strong reception, and fund flows stayed positive, including $800 million flowing into exchange-traded funds. This week's outsized new issue calendar is expected to be well received, with unspent proceeds from September reinvestment providing support.

The municipal market maintains strong demand driven by several factors: Treasury market stability, light new issue supply over the past two weeks, and substantial unspent September reinvestment funds seeking deployment. While the new issue calendar is accelerating, supply levels appear manageable.

We continue to view municipals favorably, with tax-exempt yields reaching attractive levels of 4% in the intermediate range and 5% for longer maturities. We expect this environment to persist through year-end.

The New York Metropolitan Transportation Authority issued $1.4 billion in transportation revenue bonds (rated A2/A) that were priced to sell and received strong investor interest. The deal included 5% coupon bonds maturing in 2041 at a 4.21% yield, highlighting the attractive intermediate tax-exempt yields currently available.

High yield municipals attracted strong inflows of $425 million last week. The average high yield muni index yield held steady despite modest pressure from the broader rate market. High beta credits continued to benefit from increased demand and constrained supply, with Buckeye Tobacco spreads tightening further. Secondary market momentum remained strong, as Chicago Board of Education new issue bonds traded 5 bps tighter than original pricing. Looking ahead, we are tracking 13 new deals totaling a modest $740 million in par value for this week.

Credit spreads tightened further to 72 basis points, reaching multi-decade lows.

In focus: The Fed cuts and signals more to come

Last week the Federal Reserve trimmed interest rates by 25 basis points - its first rate reduction since last December - bringing the fed funds rate to a new target range of 4.0% - 4.25%. Citing increased downside risks to employment despite stable baseline forecasts, the Fed penciled in additional easing ahead.

The Fed's updated summary of economic projections showed only a small upgrade to real GDP growth and no changes to the unemployment or inflation outlooks. However, its policy statement referenced that "job gains have slowed" and "downside risks to employment have risen." This heightened focus on potential labor market weakness justified a shift in the Fed's heavily scrutinized dot plot of projected rate changes, which now implies a total of 75 bps of cuts for 2025, up from 50 bps in June.

At his press conference, Chair Jay Powell emphasized the high degree of uncertainty in current conditions, acknowledging that the two sides of the Fed's dual mandate are "somewhat in tension" and observing "it isn't incredibly obvious what to do."

We continue to expect 75 bps of additional easing over the next few quarters, and the chances of a cut at the Fed's October meeting have risen. Given the central bank's concerns about the labor market, the next jobs report on 03 October will be particularly critical for future policy decisions.