Bond market volatility persists as Fed holds rates

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Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

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Jeffrey Mayberry, fixed income asset allocation strategist and portfolio manager at Double Line Capital. 

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Up until about the middle of February, the U.S. bond market has been in a pretty significant sell-off in terms of interest rates. And they’ve been at recently high levels, and we’ve been at a place where the momentum really has been towards higher rates. 

The U.S. economy continues to be strong at the end of the fourth quarter. And, really, you saw inflation remain at a little bit higher level than maybe the Federal Reserve was comfortable with. All that kind of put together caused interest rates to be at a higher level. 

There’s growing concern, I would say, about the U.S. federal deficit. And the fact that that was continuing to grow also puts further upward pressure on interest rates. 

Now, since mid-February, there’s been some growing growth concerns in the U.S. Consumer confidence has come down, and there is a little bit more of a concern from the bond market and the stock market — both major markets — that the U.S. growth is not going to be as robust as it was in 2024. 

You started to see it in such data as the ISM manufacturing data. You started to see a lot of the import numbers come in. The Atlanta Fed GDP Now numbers have turned negative — and it’s still very early on for the Atlanta Fed GDP numbers, we don’t put much stock in it because as we go through the quarter you get more and more data and more revisions to the data — but it was a pretty significant downturn in that metric. 

And so there have been some growth concerns. And so you did see a pretty significant rally in U.S. interest rates going into the end of February. We think this is probably more short-lived, and that we should see a rebound in rates, especially on the longer end of the curve rates should continue to go higher. 

As we become more and more concerned about what the Presidential administration in the U.S. and the U.S. Congress is going to do in terms of tax cuts, and more specifically the deficit and whether that continues to grow — which certainly seems likely — we think that at some point that will overwhelm the negative sentiment going on. The bond market will become much more concerned with the growing budget deficit and really put upward pressure on interest rates. 

Where we are now, the growth concerns are at the forefront over the short term. Over the medium and long term, the bond market sell off could likely continue. 

The Federal Reserve has maintained that they are going to continue to target a 2% core PCE inflation. When you think about core PCE, that’s ex food and ex energy. And really that data has come down to a level that maybe the Fed is becoming more comfortable with, but we’re not back to that 2% level. We’re around 2.5% as of the February reading of core PCE. 

And when you slice and dice it, there are still some components of the inflation that are at higher levels and are coming down very slowly. Something like the U.S. housing sector is continuing to come down but coming down very slowly. 

And so it makes sense that the Fed is going to remain data dependent, that they’re going to keep rates higher for longer, because they really need to get inflation down to 2%. 

There are some signs that we may get headline inflation. So, including food and energy, those numbers will continue to come down as we’re coming off a relatively high level of energy prices from last year. Those levels will come down but we think that the core PCE is going to continue to take its time coming down. And the Fed will remain higher for longer. The Fed will keep rates at relatively high levels. 

At the beginning of March, the market is pricing in two and a half Fed cuts for the rest of 2025, the first one coming in June. That seems about right. It gives the Fed some runway to see what the data comes out as, and for them to be able to react to incoming data. 

If inflation comes down faster, then that will mean that the Fed can cut rates faster. If inflation remains higher, then they will stay higher for longer. And certainly this is going to impact the fixed-income markets. And if we get that lower inflation, the Fed can cut rates, I think you’ll see the bond market react correspondingly. And longer-term rates should come down. 

You could see a divergence, though, between the short-term rates and the long-term rates, depending on growth outlook for the U.S., but really you’re at a place where — it feels like we’ve been in this place for the past couple of years — we’re very data dependent and want to see how quickly inflation comes down. 

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The Canadian fixed-income market is in a very interesting place today. 

Certainly the geopolitical risks are at very high levels. It depends on how the energy markets and the commodity markets are going to react to what is happening in the U.S., and correspondingly, what the Canadian government is going to do. 

But really, you’re looking at the Bank of Canada cutting rates pretty aggressively, and a pretty high-interest rate differential between Canada and the U.S. And so I think that the Canadian market is bound to perform well, relative to the U.S. market. 

A lot of that is going to be depending on growth in Canada, how that’s going to shake out, and what’s going to happen in Canada relative to the U.S. 

As I mentioned earlier, the Federal Reserve is probably going to be a little bit slower to cut rates. So you can kind of take advantage of those interest-rate differentials where it makes sense. But we think that it’s a relatively attractive space and certainly gives us some opportunities for relative value. 

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The current landscape for the fixed-income market across the globe is very interesting. There are pockets of opportunity, places where if you have a relatively wider spread, you have the potential for further spread tightening, which can increase your prices and lead to a higher total return. Certainly you can look at something like the commercial mortgage-backed security space. 

There’s ample opportunity, depending on how much risk you want to take, and something that we’ve been big proponents over the past few years because that market is trading at relatively wide spreads. Being able to pick and choose which subsector of the commercial mortgage-backed securities market gives you some good relative value opportunities. 

Right now we very much like the agency mortgage space. Now, spreads are still relatively wide. Banks haven’t come in to buy agency mortgage-backed securities as much as they were pre-Covid. And so spreads are at a place where they can continue to tighten. 

It does have that zero-credit risk. It is maybe not explicitly backed by the U.S. government, but certainly they have an implicit guarantee from the U.S. government. 

And so you’re at a place where you can use mortgage-backed securities as a U.S. Treasury complement, and be able to pick up some higher yield, get some lighter spreads. And really you can pick and choose where you want to be in duration. 

So, if you want to have a low-interest-rate risk, you can buy agency residential mortgage-backed floating rate risk, and really be able to sleep at night, not have to worry about that, and really could see some spread compression on that side of things, both if we get a recession here in the U.S., which is a potential. The probability of that occurring is a little bit higher today than it was at the beginning of 2025. And because of that, you can get some spread tightening in the flight-to-quality and the agency mortgage-backed security space — both on that floating-rate side and in the pass-through space. So those are really the two sectors we like the most. 

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What other things are we worried about going into the rest of 2025? 

Certainly the potential slowdown in growth is something that we are keeping an eye on. Whether the consumer confidence is something that — while we don’t necessarily look at the survey data and think that this is a great data point, we’re going to trade based off of it — what we want to do is look at it and kind of feel how the market is reacting to it. And when the market is reacting negatively to the consumer confidence numbers, then that means that there is that potential for a growth slowdown. 

When we look at something like future inflation expectations — we don’t really believe in that survey data, but — overall, when you look at the median data point, that inflation is trending to be higher. So I think you could get the dreaded stagflation scenario, where you have higher inflation, slower growth, and that is something that, over the end of February, early March, has reared its ugly head again as another potential outcome.  

As opposed to the no-landing, soft-landing, hard-landing scenario, you have this stagflationary scenario as another potential outcome. 

It’s still a very low probability event, but the fact that people are discussing it and starting to be worried about it will continue to weigh on markets as a potential outcome. 

The no-landing scenario doesn’t seem as highly probable today, at the beginning of March, as it did middle-end of 2024. That seemed like a high-probability event — that U.S. economy was just going to cruise along. We think that over the first half of the year we’re still likely to cruise along. It’s the second half of the year that we are starting to see some potential speed bumps out there, and something that, when we do to our asset allocations, do we want to be a little bit less heavy on the credit risk side of things, more on the flight-to-quality, no credit risk side of things, as that potential for a slowdown in the second half of the year increases.

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The views expressed in this material are the views of DoubleLine® as of the date of publication unless otherwise indicated, and are subject to change at any time.

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