Federal Reserve (Fed) Chairman Jerome Powell, speaking at the annual Jackson Hole gathering of global central bankers in late August, sent an unambiguous message that the Federal Open Market Committee’s focus has shifted from fighting inflation to maintaining full employment. As a case in point, he declared that “we do not seek or welcome further cooling in labor market conditions.” The Fed’s subsequent 50-basis-point¹ rate cut at its September meeting confirmed that policymakers believe the tide has turned sufficiently toward the employment side of their mandate to warrant strong action.

After several years in which the Fed primarily focused on price stability, a world where risks are more balanced between the inflation and employment outlooks is a return to an environment that most fixed income investors know well and have navigated before. We believe this normalization is a healthy evolution for markets broadly and bodes particularly well for fixed income assets.

Encouraging signs of return to negative correlation between bonds and equities

Market activity has been hinting at a return to normalcy since mid-summer as bonds and stocks stopped moving in lockstep. This was evident when volatility flared up on August 2, when July payrolls data were considerably weaker than expected and showed an increase in the unemployment rate to 4.3%, triggering the Sahm rule recession indicator.² Then on August 5, when the VIX measure of equity volatility exploded higher, investors witnessed the hallmarks of a traditional “risk off” environment.

Market moves, August 2–August 5:

• S&P 500 Index: -4.8%
• VIX: +107%
• 10-year U.S. Treasury yield: -19 basis points (bps)
• 2-year/10-year U.S. Treasury curve: +4 bps
• 10-year inflation breakeven: -11 bps
• Brent crude oil: -4.1%

Following a multi-week recovery from the early August turbulence, a slate of weak economic data greeted investors returning from the Labor Day holiday, and markets reacted similarly. While market uprisings such as these are unsettling, these reactions suggest a reversion to traditional relationships, which has important implications for portfolios.

“While market uprisings such as these are unsettling, these reactions suggest a reversion to traditional relationships....”

The correlation³ between risk assets, such as the S&P 500 Index, and U.S. Treasuries could be the most important relationship to track when looking for confirmation of market normalization. From the late 1990s through 2021, the low or even negative return correlation between these two asset classes was something investors could count on for diversification benefits. This was particularly important during growth shocks, when risk assets sold off while Treasuries—viewed as a safe-haven asset—rallied. This reliable market reaction helped make fixed income an attractive allocation within a broad portfolio—not only could investors look to it for income and stability, but it also helped to buffer a portfolio during adverse equity episodes.

However, as the market narrative shifted to “inflation scare” in 2022 for the first time in decades, many investors began to question the wisdom of holding a fixed income allocation. Equities sold off along with Treasuries, contrary to their usual behavior. Inflation and growth expectations impact both Treasuries and risk assets. High and unexpected inflation shocks drive both in the same direction—and, typically, neither performs well in that environment. 

However, growth shocks have opposite effects that tend to be positive for Treasuries as a safe-haven asset and negative for credit and equities as markets start worrying about declining revenues and a potential recession. When inflation is controlled (i.e., around 2% or lower), growth tends to be the primary driver for both Treasuries and risk assets—typically, in opposite directions. In this environment, the correlation tends to be low or even negative. However, as inflation rapidly increased through 2021 to 2023 and remained high, both Treasuries and equities were negatively impacted, and correlations turned positive. 

Now that inflation has moderated to within striking distance of the Fed’s 2% target, we have seen a revival of negative correlations, particularly as economic data disappointed over the summer. The 30-day correlation between the returns of Treasuries and the S&P 500 as of September 30 was -0.06. As long as inflation continues to moderate, the prior relationship should resume. 

The Fed is on top of things and may have achieved a rare soft landing

The Fed is engaging in a tightrope act. History is replete with many instances where the Fed overstayed its welcome in the restrictive federal funds rate zone, ultimately leading to recession. Depending on the definition of soft landing, there have only been two of these elusive events since 1960.

However, we are cautiously optimistic that the Fed will succeed in achieving a soft landing, as a recession in the next six to 12 months is not our base case. While the employment picture has weakened, consumers and corporations are still in relatively healthy financial shape. Additionally, this cycle lacks the clear signs of excess that were hallmarks of past economic downturns and financial crises.

“Given our views on the economy, we do not expect a deep Fed easing cycle....”

While we believe the economy is on sound footing overall and do not anticipate an imminent recession, it gives us comfort that the Fed is now laser-focused on downside risks to growth. The Fed has the willingness and ability to counter any burgeoning weakness by lowering a still-elevated federal funds rate. Given our views on the economy, we do not expect a deep Fed easing cycle, but we do expect continued easing to reflect abating inflationary pressures, a softening labor market, and the Fed’s desire to avoid a hard economic landing. 

Still-elevated yields to draw investors to many credit sectors

The implications of a shallow easing cycle are varied across credit sectors. Yields that remain elevated relative to much of the post-global financial crisis recovery combined with healthy fundamentals should continue to draw investors to high-quality credit sectors such as corporate bonds, agency mortgage-backed securities, and various segments of securitized credit markets.

“...ample access to financing supports the fundamental health of issuers.”

Investment-grade corporates have been particularly buoyed by the elevated yield environment, eliciting strong investor demand this year. Corporate issuers have taken advantage of the demand for investment-grade debt and delivered historically high levels of issuance. Given that balance sheets were unusually strong going into the Fed tightening cycle that began in 2022—after having emerged from the brief 2020 recession—ample access to financing supports the fundamental health of issuers. While credit spreads⁴ are narrow, both the technical and fundamental backdrops for the asset class remain supportive.

However, a shallower easing cycle could present challenges to troubled areas like commercial mortgage-backed securities (CMBS) that could benefit from a more pronounced decrease in rates. Amid secular challenges such as the work-from-home trend and its impact on office space, the economics of many parts of commercial real estate—in particular, assets financed with floating rate loans that are more directly linked to the Fed’s policy rate—simply don’t work unless interest rates come down more meaningfully.

While lower rates could act as a balm for lower-quality companies in the high yield bond and bank loan space, many of these issuers have been effective at refinancing their outstanding debt to extend their maturities. This should help alleviate near-term financial stress if rates don’t drop dramatically. In addition, current yields on high yield bonds and bank loans present very attractive alternatives to equities with potentially lower drawdowns in a broad market sell-off. These characteristics make these sectors attractive allocations in a multi-asset portfolio as markets emerge from the high-inflation environment of the last few years. Of course, more speculative sectors such as high yield bonds and bank loans necessarily require thorough credit analysis as performance dispersion is high, and default rates in some sectors are normalizing higher from historically low levels.