Summary:

The Fed has resumed rate cuts, citing slowing job gains and downside risks to employment. This comes despite elevated inflation and a still-growing economy.

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Our Perspective:

The fiscal dominance (when deficits and debt dynamics limit monetary policy’s room to maneuver) described in the third quarter outlook is now being met with more accommodative monetary policy in light of the economic headwinds faced by a tighter labor market. 

The market response to the resumption of rate cuts by the Fed has presented an opportunity to reposition the fixed income allocation of most multi-asset portfolios to take advantage of yield curve steepening and higher term premiums (the extra yield investors demand to hold longer bonds). 

Is Policy Late - Or Right on Time? 

The second and third quarters of the year have been bookended by fiscal actions that have added significant difficulty to the work of the Fed in restoring price stability within the economy. 

First and ongoing has been the use of trade policy as a diplomatic tool. The trade-weighted average tariff rate currently stands at 18% (8% if we exclude court-challenged tariffs) domestically. This situation adds burdensome challenges to businesses that require stable input prices in order to make long-term investments and commit to capital projects.

This was followed by debate over the persistently large and growing fiscal deficit, a more significant portion of which has become the interest on the debt used to finance it. This is not only a US problem, but a problem for the bulk of the Group of Seven (G-7) economies around the globe.

Line chart titled “US Debt Interest Payments” showing data from December 2000 to October 2024. The x-axis represents time in years, and the y-axis ranges from 0 to 1,400 billion dollars. The orange line starts near $350 billion in 2000, remains relatively flat with slight fluctuations until around 2016, then begins a steady upward trend. After 2020, the increase accelerates sharply, reaching approximately $1.2 trillion by late 2024.

This is the situation in which the Federal Open Market Committee (FOMC) finds itself. After remaining on pause and assessing the cumulative impact of the 1% rate cut delivered in 2024, the FOMC resumed cuts in September, lowering the overnight rate by 0.25%, penciling in two more quarter-point rate cuts for the remainder of this year and two more for 2026.

Line chart titled “Fed Funds Rate vs Primary Budget Deficit” showing data from September 1989 to September 2024. The x-axis represents time in years, and the left y-axis shows the Fed Funds Rate (0% to 10%), while the right y-axis shows the Budget Deficit as a percentage of nominal GDP (inverted scale from 0% to -20%). The dark blue line represents the Fed Funds Rate, which starts near 9% in 1989, declines steadily through the 1990s, rises to about 6% in the mid-2000s, drops near 0% after 2008, remains low until 2016, then climbs to around 2.5% by 2019, falls again in 2020, and rises sharply to about 5% by 2023. The light blue line represents the inverted budget balance, showing deeper deficits during recessions, with notable spikes downward around 2009 and 2020. Red arrows highlight periods of rate increases, and a red circle emphasizes the recent deficit near -6% in 2024.

 Growth Firm, Labor Softer: The Split Screen

It’s unusual that fiscal and monetary policy are loosening while the economy is growing at 3.8% in inflation-adjusted terms, but that is the current situation. 

In fact, evidence is mounting that financial conditions have become looser, and economic data has generally surprised to the upside, especially as services inflation continues to march lower incrementally. This is despite the fact that there are credible and tangible signs of a weakening in labor market conditions, which have largely served as the rationale for the FOMC’s recent moves.

Line chart titled “GS US Financial Conditions Indices” showing two indices from 2013 to 2025. The x-axis represents years, and the y-axis ranges from 96 to 102. The dark blue line represents GS Nominal FCI, and the light blue line represents GS Real (Inflation-Adjusted) FCI. Both indices fluctuate around 99–100 for most of the period, with notable dips near 97 in 2020 and peaks above 101 in 2018 and 2023. The chart indicates periods of tightening when values rise above 100. Source: Goldman Sachs Global Investment Research.

What’s more, Jason Thomas, Carlyle Group’s (a major private equity firm) head of Global Research and Investment Management, recently stated, What’s so interesting about the moment we’re in is the discrepancy between payrolls and the other economic indicators we’re looking at, referring to the weakening jobs data despite other indicators broadly portraying resilience. 

Line chart titled “Jobs/Workers Gap” showing data from October 2005 to December 2024. The x-axis represents time in years, and the y-axis ranges from 0 to 2.5. The blue line shows the ratio of job openings to available workers. It starts near 0.6 in 2005, dips below 0.3 during the 2008–2009 recession, then gradually rises over the next decade. After 2018, the gap exceeds 1.0, briefly plunges near 0.2 in early 2020, then spikes sharply to around 2.0 by 2022 before declining toward 1.0 in late 2024. A red dashed line marks the 10-year average at 1.1, with a label “10y avg is 1.1.”

Recently, the number of jobs available to unemployed workers dipped below 1 to 0.98. The jobs/workers gap, as the measure is more colloquially known, is a key barometer of labor supply and demand and is often cited by FOMC members in the context of the health of the labor market. Additionally, the number of temporary help services payrolls, a leading indicator of labor market health, has deteriorated to about 2.5 million. These levels are similar to those of late 2012, when the economy was still recovering from the financial crisis.

Just Do the Twist

The proposed fiscal solution to the issues of trade, deficits, and the cumbersome debt servicing costs has been to skew treasury issuance to the short end of the yield spectrum. The observed effect has been a stickiness in long-term rates, albeit lower than one would otherwise expect, and a steepening in the yield curve.

Line chart titled “US Treasury Yield Curve” comparing two yield curves: the current curve and the curve as of December 31, 2024. The x-axis shows maturities from 1 month to 30 years, and the y-axis ranges from 3.25% to 5.00%. The light blue line represents the earlier curve, starting near 4.2% at 1 month, dipping to about 3.5% at 2 years, then gradually rising to around 4.3% at 30 years. The dark blue line represents the December 31, 2024 curve, starting near 4.3% at 1 month, dipping slightly at 2 years, then climbing sharply after 10 years to a peak near 4.8% at 20 years before easing slightly at 30 years. Red arrows highlight the dip at 2-year and 5-year maturities, and a red oval emphasizes the peak at long-term maturities.

Separate from issuance strategy choices, the uncertainty around whether trade will be freer and/or austerity measures taken makes it exceedingly difficult for a central bank with an explicit dual mandate of price stability and full employment to operate. Thus, the FOMC has elected to prioritize the employment side of its mandate, while alluding to the risks associated with its often-overlooked third mandate of maintaining moderate long-term interest rates. 

Given the moves in rates over the past nine months, the team felt that it would be optimal to reposition fixed income allocations to take advantage of these realities. The 3- to 7-year maturity portion of the Treasury curve (the ‘belly’) appears to be fully valued at this juncture; thus, we elected to take profits and reallocate these proceeds into mortgage-backed securities (MBS), long-maturity US Treasuries, and short-dated asset-backed securities (ABS). 

MBS carry a desirable yield of 4.5% and provide protection should rates move higher. Longer-dated Treasuries, as discussed earlier, carry yields that have remained relatively high, and ABS, while possessing similar protections against rising rates, carry a yield closer to 5%. 

It’s important to note that these changes further enhance the resilience of client portfolios by focusing the already limited credit risk on the very short end of the yield curve, while interest rate sensitivity is added via the allocation of long-end Treasury notes.

This positioning should allow our clients to take advantage of the steepening of the yield curve, while also hedging against any prolonged weakness in labor market conditions. We will continue to monitor these developments in the macro economy and reposition fixed income allocations to serve as a source of safety and liquidity. 

Resilient portfolios start with intentional positioning. Connect with a Midland Wealth Advisor to review your fixed income strategy and explore opportunities for balance and protection.

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