Mike Sanders | Head of Fixed Income, Madison Investments
Key Points
Position for further yield curve steepening
Expect continued yield curve steepening, as mounting fiscal burdens, dollar weakness, and softening foreign demand push long-term rates higher.
Know your issuers
Credit selection will be important in the second half of the year, as trade-related volatility and diverging corporate fundamentals create a wider gap between winners and losers of the trade regime.
Move out of cash
With rate cuts likely ahead, the yield and return potential of intermediate fixed income offers a better long-term alternative to cash.
The theme of 2025 so far has been uncertainty, both fiscal and monetary. The early April tariff announcement introduced significant volatility into the market, prompting the Federal Reserve (Fed) to respond with excessive caution. The eventual shape and scale of the tariffs remain unknown, and how businesses and consumers will absorb those costs is equally unclear. As a result, the potential outcomes for both the economy and markets are wide-ranging.
Bond market performance in the first half of the year was largely driven by expectations around Fed policy and the U.S. fiscal situation. Tariff policy injected considerable uncertainty, likely delaying investment decisions from businesses and contributing to a slower growth outlook. Combined with a cooling employment picture, markets quickly began pricing in a more aggressive rate-cutting stance from the Fed. At the long end of the yield curve, the proposed spending bill and its funding obligations have pushed long-term interest rates higher.
As we sit mid-year, the bond market is more concerned about a slowing labor market than a resurgence in inflation. With additional rate cuts now priced in, the market appears to believe the Fed is more likely to respond to labor market weakness than to slightly higher inflation. We share that view and expect the Fed will lean toward cutting rates later this year.
Where we differ from the market is in our longer-term view of where this cycle will end. We believe the terminal rate for this cycle should settle around 3.25%, compared to the market’s expectation of sub-3%.
We think the market is underpricing the potential for inflation to remain elevated. If businesses pass along more of the tariff-related costs and price levels remain elevated, and if the labor market does not weaken significantly, the Fed may not follow through with rates that the market has baked into assumptions. This scenario could have meaningful implications for both credit and equity markets.
Fiscal Concerns and Yield Curve Management
At the other end of the yield curve, we expect long-term rates to stabilize or potentially rise slightly. Absent a severe recession and an aggressive cutting cycle, we don’t see the back end of the curve falling meaningfully below 4%. In fact, the fiscal backdrop in the U.S., combined with recent dollar weakness and softening foreign demand for Treasuries, may place additional upward pressure on long-term yields.
The combination of a falling dollar with rising long-end rates suggests increasing concern about the U.S.’s long-term fiscal health and economic strength. A weaker dollar makes imports more expensive, which could nudge inflation higher. Typically, in a risk-off environment, we would expect a stronger dollar and lower U.S. interest rates. However, given the current policy backdrop, that relationship appears less reliable than it was in the past.
For investors concerned about these risks, we believe intermediate-term fixed income makes sense. It offers less exposure to long-end volatility, which could have an outsized impact on portfolio performance in the current environment.
Be Selective with Credit
In the credit market, the April tariff announcement caused a sharp but brief widening of spreads. Since then, spreads have largely retraced to their pre-announcement levels. Still, given the wide range of outcomes from trade policy and its potential impact on growth, we expect more volatility in the second half of the year. We anticipate that corporate fundamentals may weaken in certain sectors, and credit spreads will likely reflect this by widening into year-end.
There are areas of the credit market that still offer value, but selectivity will matter more going forward. Trade negotiations will likely create winners and losers, and not all companies will be equally equipped to handle tariff-related pressures. Broadly speaking, the credit market doesn’t seem overly concerned about the potential negative impact of tariffs. As such, blindly buying all credit is not the right way to approach this environment.
Demand for fixed income remains strong, but fundamentals will ultimately prevail. If corporate fundamentals deteriorate in response to tariffs, we could see a return to the kind of volatility experienced in April. While spreads can remain tight for extended periods, they do eventually widen. This is why we maintain our quality bias in portfolios. In our view, staying in higher-quality credit makes more sense than reaching for the final few basis points in lower-rated bonds.
From a positioning standpoint, we are finding value in select areas of the corporate bond market, specifically in the Financial sector with bank bonds. We also favor agency mortgage-backed securities (AMBS), with an emphasis on strong prepayment characteristics, and diversified across the curve to mitigate prepayment risk. By contrast, investors in high-yield and even BBB-rated industrial bonds are not being adequately compensated, given the wide distribution of outcomes mentioned earlier.
Looking Ahead
As we enter the second half of the year, we believe the environment remains favorable for active fixed income management. We expect further steepening of the yield curve, sector and issuer level dislocations due to trade policies, and a persistence of volatility that should continue to present opportunities. Active managers who can adjust duration, rotate credit exposure, and identify value along the curve are well-positioned to add value. In this market, a hands-on approach grounded in issuer fundamentals and macro awareness is especially important.
We also continue to believe that cash is not a long-term investment solution. While current cash yields are relatively high, intermediate fixed income offers the potential for higher yields along with reduced reinvestment risk. If the Fed resumes cutting rates, cash yields will decline. Allocating strategically to fixed income today may better position investors for their long-term investment objectives.