The range for the 10-year treasury yield has been squeezing narrower over the last two years. After rates lifted off from near zero in 2020 and peaked near 5% in late 2023, the 10-year yield has dampened its swings around the 4.25% mark, just as the metal balls in the popular 1970’s toy do after the release of a ball at the end. During that time, the Fed ended its tightening cycle, paused, began a cutting cycle, paused again, and here we are. Just when nobody has picked up an end ball and let it swing in a while, it looks as though the Fed is going to give it another try.
Will they or won’t they seems to be less of a question than how many balls are they going to let go and how often. The market says six times, more or less, by December of 2026, which would bring the Fed funds rate down to 2.75% from 4.25%. Interestingly, the rate on the ten year and the rate on the 3 month T-bill, in our view, have been rhyming for most of 2025. Will they still rhyme if Fed funds is at 2.75%? Even the Fed dot plot doesn’t say they are going to go that low. It says they will go to 3.6% at the end of 2026 and to 3.0% in the so-called “long run.” Not that it matters, neither the dot plot nor the Fed Funds futures predictions have proven to be all that accurate that far out.
Where it actually ends up does matter for the capital markets though. Which is why, in our view, everybody tries to predict it. But accurately predicting where the fed funds rate will be in 18 months is very hard, and even then, it’s not what investors really want to know. We think what they really want to know is where long-term rates are going to be, what credit spreads are going to do, and what equities are going to do. That’s even harder. By a lot.
One theory is that long term rates come down too, and equities take off to the upside. Wouldn’t that be great? Just buy everything. But it’s also possible that long term rates go up. And then maybe equities go down because of the higher discount rate. But maybe equities go up instead because higher rates are the result of a stronger economy. Or something.
The path of many variables figures heavily into how that plays out. Understanding those may give some better clues as to how to allocate assets. Let’s limit this to inflation, employment, debt and the resilience of the economy for now.
Inflation has been remarkably steady for the last 18 months. Once Core PCE nudged below 3.0% in February of 2024, it spent most of it has time between 2.7 and 2.9%. Upward pressure on some prices has been offset by downward pressure on others. Tariffs are one of many influences, and their ultimate effect on inflation is still highly uncertain. And now the nature of their existence is highly uncertain. That said, the inflation path still looks to us to be more likely to be steady to lower rather than breaking away higher. That would be good news for equities and bonds.
Employment has been trending toward the weaker side though. In past cycles, weakness has begotten further weakness. Further weakness could push the economy into recession, an outcome not currently expected by the markets. If short term rates come down due to recession, equity markets may falter.
Government debt levels are high and are refinancing at higher rates. A recession typically results in lower government revenue collection which would put upward pressure on the deficit. Investors might require higher rates to induce them to buy bonds. In that case, both bonds and equities could lose value at the same time.
The economy has surprised to the upside over the last several years. Fiscal stimulus has helped. Restrictive monetary policy has not quelched. People and companies have shown significant adaptiveness. Entrepreneurial spirit continues to find new ways to improve productivity and efficiency and to create things people want and find valuable. Perhaps the most optimistic path forward depends on this continued resilience.
Good diversification is the best offense and defense. When such different outcomes all have significant probabilities of coming true, it’s best not to just guess. We view our strategies as being participatory but conservatively positioned and will stay that way until we see enough evidence to warrant a different position, one way or the other.
By Thomas Martin, CFA
Originally published at Globalt Investments
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