For most of 2025, there have been expectations that the Fed is going to lower interest rates. However, those expectations have not been realized.
For most of 2025, there have been expectations that the Fed is going to lower interest rates. Thus far, however, those expectations have not been realized as the Fed funds rate has been at its current 4.25-4.5% target since December of last year. While the market has gradually extended its timeline, it has not given up on a reduction in 2025. Currently, the fed futures market is pricing in about a 55% chance that the Fed will cut rates in September. But the odds of a September cut have fallen noticeably over the last week despite June CPI coming in largely in line with expectations.
As to why the odds of a September cut have fallen recently despite the relatively low June CPI number, the explanation may be that there are signs that, while it remains low, inflation may be turning higher. Goods inflation has been ticking higher over the last few months, and several measures of underlying inflation have recently turned higher. These data point are just a possible sign that inflation could be rebounding, and at this point, the market is still pricing in a better than 50% chance of September cut. However, the possibility that inflation could be on the upswing combined with a Fed that seems to be in no hurry to act given the resilience of the economy, may be causing investors to question their timeline once again.
While the timeline has been adjusted several times, the market has been consistent in its expectation that the Fed will lower rates in 2025. Despite this, longer-term rates have not fallen meaningfully as the 10-year yield index (TNX) is currently trading near where it was at the end of last year and except for a quick dip in April, TNX has not fallen below 4% this year. Fed policy does not directly impact the long end of the curve, but long-term yields reflect where the market expects short-term rates to go. This is why inversion of the yield curve is considered a sign of recession – it reflects an expectation that short-term yields are going to fall in the future. By that logic, it’s not unreasonable to think that when the market is expecting the Fed to cut rates, it would be reflected in long-term yields, but that has not happened. Aside from uncertainty about when the Fed will finally act, concerns about the US debt, which have been at the forefront this year, may be helping to keep yields higher.
Whatever the exact cause, the upshot is that, as has been the case quite often since 2022, strength in fixed income lies outside the core US market. Global and non-US groups have been one of the most reliable areas of strength in fixed income this year as the dollar has trended lower virtually all year and these groups still account for five of the top 10 groups in the Asset Class Group Scores fixed income rankings. Recently, however, convertible bonds have moved to the top of the rankings and show the highest score direction of all fixed income groups in the system.
If you’re unfamiliar with convertible bonds, they are hybrid securities with features of both debt and equity. They give the bondholder the right, but not the obligation, to exchange the bond for a pre-determined number of shares of the common stock. In a situation where the underlying equity value of a convertible bond is higher than its conversion price the bond will generally trade much like equity, i.e., the price of the convertible bond rises and falls with the stock price, so convertible bonds will often perform well when the equity market is strong, even in an unfavorable interest rate environment, making them a good option for markets like this one. It is worth noting that because of their equity-like characteristics, convertibles can be significantly more volatile than traditional bonds and they can reduce the diversification benefit of your fixed income portfolio, so you will probably want to limit your level exposure.
Overall, the fixed income market seems to be at something of a crossroads, inflation has come down enough that the fed could lower rates, but with the uncertainty surrounding tariffs and a relatively strong economy, they have been content to sit on their hands. It may take a noticeable economic shift – like a significant upswing inflation or a major weakening of the labor market to shake things loose. But at present, relative strength continues to lie mostly with non-core groups like international fixed come, high yields, and convertibles. For those looking for safety in fixed income, short duration Treasuries and investment grade bonds are probably the best option as a one-year Treasury is currently yielding more than the five-year bond.
