Central banks, AI and tariffs pressure Treasury yields lower

Weekly fixed income update highlights

• Treasuries, MBS, investment grade and high yield corporates, senior loans and emerging markets all had positive returns.
• MBS, agencies and emerging markets outperformed similar-duration Treasuries.
• Municipal bond yields declined across the curve. New issue supply was $7.6B, and fund inflows were $742M. This week’s new issuance is undersized at $7B.

U.S. Treasury yields moved lower again and spreads generally widened, on concerns about the U.S. growth outlook and tariff policy. The U.S. Federal Reserve kept rates steady and the European Central Bank cut its policy rate, as expected.

Watchlist

• 10-year Treasury yields declined last week, and we expect yields to remain rangebound during 2025.
• Spread sectors generally underperformed Treasuries, and spreads remain tight.
• We expect the technical environment for muncipal bonds to remain strong this year.

Investment views

Rates have peaked for this cycle, and attention has pivoted toward the pace and size of rate cuts in response to softer growth and easing inflation.

The underlying growth outlook remains healthy thanks to strong consumer balance sheets and solid levels of business investment. This combination should keep corporate defaults low.

Risk premiums may widen further, with entry points for taxable fixed income likely to become more attractive over the coming quarters. Credit selection remains key as we search for bonds with favorable income and solid fundamentals.

Key risks

• Inflation fails to continue moderating as expected, weighing on asset prices.
• Policymakers unsuccessfully juggle fighting inflation with supporting economies still struggling to gain traction.
• Geopolitical flare-ups intensify around the world.

Emerging markets lead performance and inflows return

U.S. Treasury yields fell again last week, with 10-year yields ending 8 basis points (bps) lower at 4.54%. 2-year yields moved similarly, down 7 bps to 4.20%. It was a busy week of macro news, including central bank meetings in the U.S. and euro area. The Fed kept rates steady, though Chair Powell leaned hawkish in his comments. The European Central Bank cut its policy rate by 25 bps, as expected. Those moves helped yields to move somewhat lower, but the bigger moves came earlier in the week. Monday’s headlines about a new AI program from China’s DeepSeek caused risk assets to weaken and Treasury yields to decline. Markets were also impacted late Friday by trade policy-related headlines, with yields generally moving higher and spreads widening in advance of possibly inflationary tariffs.

Investment grade corporates advanced again, returning 0.34% but underperforming similar-duration Treasuries by 9 bps. Inflows accelerated again, with $4.8 billion entering the asset class. Supply was above expectations despite the week’s volatility and central bank meetings. A total of almost $31 billion priced, taking January’s total to more than $191 billion, which is more than expected. Despite the deluge, demand remained robust, with average oversubscription rates of 3x and new issue concessions of just 1.5 bps.

High yield corporates also benefited from lower rates, returning 0.20% but lagging similar-duration Treasuries by 8 bps. Senior loans returned 0.07%. Both asset classes enjoyed inflows, with $196 million entering high yield funds and $1.5 billion flowing into loan funds. That marks the fourth consecutive week of senior loan inflows totaling more than $1 billion, and the ninth week out of the last 12 weeks. Over that time, loan inflows have totaled nearly $15 billion. Pricing remains supported, with more than 50% of the market trading above par. In turn, that has continued to support refinancing activity, with $32 billion pricing for the week, compared to $7.4 billion in high yield.

Emerging markets led performance again, returning 0.51% and beating similar-duration Treasuries by 11 bps. Inflows returned at $65 million. Most of the rally came before Friday’s tariff headlines. The dollar, which tends to be a headwind for emerging markets when it is strengthening, looks to be appreciating in response to tariff news. It saw a broad gain of around 1% and more than 2% against the Mexican peso.

Municipal bond market sees heavy reinvestment money in February

Municipal bond yields declined across the curve last week. Short-term yields ended the week -7 bps lower while long-term rates declined -5 bps. New issue supply was well received, and fund flows were positive once again, including $248 million in exchange-traded fund inflows. This week’s new issue supply should again be undersized.

The municipal market remains well bid. Muni prices are driven substantially by the Treasury bond market, and an additional catalyst of $44 billion in outside reinvestment money hits the market the first trading day of February.

Debt outstanding from areas devastated by the Southern California wildfires has begun to recover in price. Many new investors see this selloff as a buying opportunity. This bodes well for the new outsized debt that will certainly be issued once the affected areas begin to rebuild.

Oklahoma Turnpike Authority priced $1.1 billion revenue bonds (rated Aa3/AA-; some bonds were wrapped by Assured Guaranty). The deal was well received, and many maturities traded at premiums in the secondary market. For example, 4.25% coupon (Assured Guaranty) bonds due in 2055 came at a yield of 4.45% and traded in the secondary market at 4.41%.

The high yield municipal market returned 0.76% in January after a volatile start to the year. High yield munis are navigating the turbulence of uncertainty based on strong fundamentals, growing demand and high embedded yields. Credit spreads are compressing, and we believe the ability to combat compressing relative value will separate the short- and long-term performers.

Senior loans have seen four consecutive weeks of inflows topping $1 billion.

In focus: The Fed hits the pause button

After cutting interest rates by 100 basis points over the last four months of 2024, the Federal Reserve stood pat last week, leaving the fed funds target range at 4.25%-4.50%. Entering 2025, the central bank is moving to a new phase of the easing cycle characterized by a slower, more cautious pace of rate cuts.

In his press conference, Chair Jay Powell stated as much, specifying that “we do not need to be in a hurry to adjust the policy stance.”

The Fed made several changes to its December policy statement, which Powell described as “a bit of language cleanup” that was “not meant to send a signal” about a shift in policy. Nevertheless, the edits leaned hawkish, no longer noting inflation had made “progress” toward hitting the Fed’s 2% target, but that it remains “somewhat elevated.” The statement sounded more optimistic about the labor market, though, saying “the unemployment rate has stabilized at a low level.”

We continue to expect two rate cuts this year, taking the policy rate to 3.75%-4.00%. The timing and magnitude should depend on the incoming inflation and labor market data, as well as policy developments from the Trump administration.

The day after the Fed meeting, the European Central Bank lowered its benchmark interest rate – the rate banks receive for deposits held overnight at the ECB – by a quarter point, to 2.75%, amid signs that growth and inflation in the eurozone are weakening.