Warming Up To Bonds

The 5-year breakeven rate, a measure of what bond investors expect inflation to be over the next five years, surged from 1.9% to 2.7% between 9/9/24 and 2/20/25 as the market priced in the likelihood of tariffs. Over that same period, the yield on the 10-year Treasury rose in lockstep, climbing from 3.7% to 4.5%.

But now that tariffs are happening, the actual impact may prove to be less inflationary than many expected. Fed chairman Jerome Powell, in an address that followed the March meeting, provided a reality check on the inflationary impact of tariffs, saying that the effects will be largely transitory (meaning short-term in nature). While the Fed increased its 2025 forecast for core inflation from 2.5% to 2.8%, it left forecasts for 2026 (2.2%) and 2027 (2.0%) unchanged. Even more surprising to some of the reporters in the room, the Open Market Committee’s dot plot continued to project two rate cuts in 2025. As he was pressed into defending these positions, Powell talked about separating the economic "signals" from the "noise," and at one point said he considered news reports to be "noise." Most importantly, Powell stated that long-term expectations for inflation (meaning over a period of five years or more) were well anchored, and that any effect from tariffs would likely be minimal.

Another consideration for bond investors is the deficit. Because federal spending in excess of tax/tariff receipts puts upward pressure on inflation, any success on the cost-cutting front (provided it isn’t undone by tax cuts or stimulus checks) would tend to reduce inflationary pressures. The current CBO projection for 2025 calls for a deficit of $1.9 trillion. If that number were to shrink by perhaps $500 billion, an inflation reduction of 25-50 basis points might be realized.

Suddenly, it seems, bonds are no longer a bad place to be. While quantitative easing suppressed yields between 2009-2022 (making it difficult for bond investors to keep up with inflation), today’s bond yields are actually compensating investors for their risks. The 10-year Treasury yield of 4.2% is almost two percentage points higher than the 10-year breakeven rate of 2.4% (the latter shows what bond investors anticipate for inflation over the next decade). This suggests good odds for beating inflation over the next decade.

There are, of course, some bond risks worth highlighting. Domestic credit spreads (which have been relatively narrow recently) have begun to widen, making high-yield bonds less attractive. And some foreign bond yields are rising for a variety of reasons, including increased defense spending in Europe and growing signs of wage inflation in Japan.

Nevertheless, if you stick with domestic investment-grade issues that emphasizes short-to medium maturities, odds are you won’t be disappointed. Intermediate Bond, for example, has less than one-third the risk of stocks, but currently offers a 30-day yield that is almost as high as the 10-year Treasury. It has good odds for outperforming both inflation and money market funds over the next five years.

First Quarter Review
The implementation of heavy-handed tariffs without a phase-in period roiled the stock market in the first quarter. A weaker dollar and higher interest rates in Japan added to the volatility, triggering another round of deleveraging activity by speculative carry-trade investors. The S&P 500 ended the first quarter with a decline of 4.3%.

The story was better on the bond side, in part because yields jumped late last year as the market braced for tariffs and higher inflation, so there was room for them to ease a bit in the first quarter. The U.S. Aggregate Bond Index gained 2.8% for the first three months of the year.

Performance-wise, our model portfolios did slightly worse than the major stock and bond indexes. On the stock side it helped that we cut risk and boosted value-stock exposure late last year, but we still trailed the S&P 500 – partly because we maintained a slight tilt toward growth stocks, but also because we overweighted the consumer discretionary sector. And on the bond side, our gains were held back by our emphasis on shorter maturities, and, in some cases by widening credit spreads in the high-yield segment.

Looking Ahead
While tariffs can be highly disruptive in the short-run, in the long-run they don’t matter much. The 10-year breakeven rate, a measure of what bond investors think the inflation rate will be over the next decade, changed only slightly (from 2.2% to 2.4%) in the first quarter. Why? There are two reasons. First, in an age of automation it is relatively easy to produce things where they are being sold. It just takes up-front capital, and these days there’s plenty of that to go around. Second, goods and agriculture only account for about 20-25% of U.S. GDP. As long as the trade war doesn’t spread into services (75-80% of U.S. GDP), the impact of tariffs during the ramp up of U.S. factory capacity should be relatively easy to absorb.

Granted, in some cases there will be significant hits to corporate earnings during the transition period. But given the first-quarter contraction in P/E ratios, the stock market has already discounted that, perhaps more than was necessary. The bigger concern is that consumers will reduce their spending because of economic uncertainty, making the earnings slowdown worse. But it’s hard to know exactly how things will play out. If tariffs end up being largely absorbed by the supply chain (a likely scenario for companies planning to move production to the U.S.), consumer spending could keep growing. If not, major purchases could be postponed, weighing on GDP. But even if that happens, a recession seems unlikely given the large amount of investment capital that could be feeding factory expansions.

With short-to-intermediate bond yields now offering a significant premium over expected inflation, investment-grade funds are now a reasonably attractive option for an investment horizon of 3-5 years. In some of our blended portfolios, we have upgraded credit quality and boosted exposure to this segment. Given the possibility that stock-fund returns may be weaker than historical norms during this period, the lower volatility that comes with a blended portfolio may not involve the usual tradeoff in performance. In other words, if you are looking for a way to reduce your exposure to stock-market volatility, this may not be a bad time to boost your exposure to bonds with a blended portfolio.

Sincerely,

Jack Bowers
President & Chief Investment Officer