When we entered the new year, the market widely anticipated a continuation of the Federal Reserve’s easing cycle (i.e. interest rate cuts) in 2026. Given the recent escalation in the Middle East, the interest rate path for 2026 has become less clear. Consensus in the market now calls for zero interest rate cuts this year – a reduction from the two rate cuts anticipated at the start of the year. In addition, the market is now pricing in the possibility of a rate hike in 2026, given the potential for upward pressure on inflation from rising energy prices. The war in Iran has certainly shifted the tides in terms of investor expectations for interest rates.
But what is the Fed telling us? Chair Jerome Powell described current monetary policy as “mildly restrictive” during his press conference, which would imply a bias toward eventually lowering rates rather than raising them. His remark is consistent with the Federal Open Market Committee’s “dot plot,” which tracks members’ projections for short-term rates. The “dot plot” shows an average estimate of year-end rates ending 25 basis points below the current level (i.e. one rate cut) – unchanged from last quarter’s projection.
Despite the Fed’s choice to sit tight and remain patient, the U.S. Treasury yield curve ebbs and flows with investor sentiment. Typically, when war breaks out, there is a “flight to quality” which drives demand for U.S. Treasury bonds and results in lower yields. However, the story has been different so far given the resurfacing of inflation concerns coupled with a continued lack of fiscal discipline. These factors drove yields higher in the first quarter both on the short-end and the long-end of the curve. As mentioned before, when bond yields go up, prices go down (and vice versa).
U.S. investment grade corporate bonds have held firm, despite the conflict in the Middle East, with yield spreads widening only 5 basis points (i.e. spreads are still tight). The bulk of investor concerns and market headlines have revolved around loans to software companies and AI disruption risk to those companies, particularly in the private credit space. While some of the headlines may just turn out to be noise, they are causing higher-than-usual redemption requests by investors. We feel it is imperative to partner with prudent credit managers that have a strong track record and exercise conservative underwriting practices. As for public debt exposure, we continue to lean on short-to-intermediate term investment grade bonds, which we feel provide attractive yields and defensive income for client portfolios.
