Treasury Bond Markets: Seeking Higher Ground

U.S. Personal Income (PITLCHNG Index), reported monthly by the U.S. Bureau of Economic Analysis, measures the total income received by individuals and households from all sources, including wages, salaries, investment income, and government transfers. U.S. Personal Spending (PCE CRCH Index), or Personal Consumption Expenditures (PCE), reported monthly by the U.S. Bureau of Economic Analysis, measures the value of goods and services purchased by U.S. residents.

Worries about the job market are also weighing on consumers. The layoffs and cutbacks in the federal government are likely to have a longer-lasting ripple effect. In addition to the decline in government jobs, contractors and workers at the state and local level may feel the impact as funding is cut.

So far, the labor market is holding steady, but the pace of hiring has slowed. In the private sector, layoffs have begun to pick up.

The pace of hiring has slowed

Source: Bureau of Labor Statistics (BLS). Monthly data from 7/31/2020 to 2/28/2025.

The Job Openings and Labor Turnover Survey (JOLTS) Layoffs data (JLTSLAYS Index) track involuntary job separations initiated by the employer that occur during the covered time period. The JOLTS Hires data (JOLTHIRS Index) track additions to the payroll that occur during the period, including new hires, rehired employees, and those recalled from layoffs.

Policy uncertainty is weighing on business investment, as well. Companies surveyed by the regional Federal Reserve banks—such as the Dallas Fed survey represented in the chart below—have cited the potential for a supply shock due to tariffs as a reason to slow spending and hiring. Higher input costs and concerns about declining demand due to retaliation are likely to limit investment.

Texas business executives' perception of business conditions has weakened

Source: Bloomberg. Monthly data from 3/31/2021 to 3/31/2025.

The Dallas Fed's Texas Manufacturing Outlook Survey (DFEDGBA Index) reflects manufacturing company executives' assessment of whether output, employment, orders, prices and other indicators increased, decreased or remained unchanged during the previous month. Responses are aggregated into balance indexes where positive values generally indicate growth while negative values generally indicate contraction. Dashed line shows the three-month moving average.

The risk is that the economy will slow to "stall speed," which makes it vulnerable to falling into recession. Economies are dynamic. Once growth stalls out, a drop in activity can develop even without outside shocks. The New York Federal Reserve's recession probability model for the next 12 months is up to 27%, which is not historically high. But the longer that growth remains tepid the more the risk will rise.

Meanwhile, inflation also has been steady. It has been holding in the vicinity of 2.5% to 3.0% by most measures for much of the past year. The price index for Personal Consumption Expenditures (PCE) has been near an annualized pace of 2.5% for the past year. Excluding food and energy, the index is stubbornly holding at around 2.8% on a year-over-year basis.

Stubborn inflation leaves the Fed on hold

Source: Bloomberg. Monthly data from 2/28/2015 to 2/28/2025.

PCE: Personal Consumption Expenditures Price Index (PCE DEFY Index) is a measure of the prices that people living in the U.S., or those buying on their behalf, pay for goods and services. Core PCE: Personal Consumption Expenditures: All Items Less Food & Energy (PCE CYOY Index) is a version of the PCE Index that excludes food and energy prices, which tend to be volatile. Both reports are published by the U.S. Bureau of Economic Analysis and show percent change.

With tariffs now a reality, prices on some imported goods are set to rise. A one-time increase can probably be absorbed by the economy, but if there is a series of tariffs affecting goods prices, then higher inflation could take hold. Given the uncertainty about how long tariffs might last, forecasting inflation is difficult.

The Federal Reserve is in a tight spot. At its latest meeting, the Fed's quarterly Summary of Economic Projections (SEP) indicated policymakers leaned toward cutting the federal funds rate. However, there is a wide dispersion among members about the timing and magnitude of cuts. Moreover, they keep pushing rate cuts into the future, given that inflation remains above the Fed's 2% target. We are still expecting one to two rate cuts in 2025, largely due to our expectation that the economy will slow and the unemployment rate will increase later in the year. However, for now Fed policy is likely on hold until the third or fourth quarter.

Seeking safety and opportunity

Since the end of last year, we have advocated a cautious approach to the bond market. We aren't prepared to increase exposure to either duration or credit risk given the current economic outlook.

Volatility is likely to remain elevated for at least a few more months until the impact of tariff and fiscal policies are visible. In addition, Congress must address the need to lift the debt ceiling and pass a budget. In the contentious atmosphere in Washington, it's not at all clear how the process will play out. Against that background, 10-year Treasury yields could rise as high as 4.75% in the near term, but in the longer term, 10-year yields could fall to 3.75% if the economy falters. The yield curve is currently positively sloped—meaning short-term yields are lower than longer-term yields—but could invert if recession risk rises.

With that range in mind, we believe a bond portfolio of intermediate duration concentrated in high-credit-quality bonds makes sense for many investors. The benchmark for the bond market we look to is the Bloomberg US Aggregate Bond Index, which tracks the performance of a broad swath of investment-grade bonds including Treasuries, other government-backed securities, and corporate bonds. It has an average duration of about 6.1 years with a current yield-to-worst (the lowest possible yield that can be received on a callable bond, assuming it doesn't default—of 4.6%. We view that as a reasonable starting point for investors building bond portfolios. It provides enough duration exposure in the event that yields fall but is low enough to mitigate some of the potential volatility if yields rebound.

We also continue to favor focusing the majority of holdings on higher-credit-quality bonds due to the potential for an economic slowdown. Lower-credit-quality bonds, such as high-yield bonds, are more susceptible to rising defaults in a weak economy. That market is beginning to show signs of concern, with yield spreads relative to Treasuries of comparable maturity widening. However, the spread is low relative to the longer-term average. We don't think it makes sense to take too much credit risk without getting a higher yield.

All in all, we are looking to move to higher ground amid the potential flood of policy uncertainty.

A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out our most recent market outlooks.

About the Author

Kathy Jones, Managing Director, Chief Fixed Income Strategist, Schwab Center for Financial Research

Kathy Jones is responsible for interest rate and currency analysis as well as fixed income education for Schwab clients and the public. She cohosts Schwab's On Investing podcast.

Prior to joining Schwab in 2011, Kathy was a fixed income strategist at Morgan Stanley, where she specialized in global macro strategy covering domestic and international bonds and foreign exchange. She has also been a consultant in the alternative investment area and previously served as executive vice president of the Debt Capital Markets division of Prudential Securities.

Kathy has analyzed global bond, foreign currency, and commodity markets extensively throughout her career as an investment analyst and strategist, working with both institutional and retail clients. She makes regular broadcast appearances on Bloomberg TV, Yahoo Finance, and CNBC, and is often quoted by The Wall Street Journal, The New York Times, Financial Times, and Reuters. She holds an MBA in Finance from the Kellogg Graduate School of Management at Northwestern University, and a B.A. with honors in English Literature from Northwestern University.

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