Second Half Bond Market Outlook

Lawrence Gillum (00:00):

It's Midyear Outlook release week here in LPL research, and we couldn't be more excited expanding on our 2025 pragmatic optimism theme. The Midyear Outlook theme is called Pragmatic Optimism, Measured Expectations. This midyear update offers fresh insights into the economic and market landscape, along with the potential impact on investment portfolios. And while I'd love to be able to cover everything in this Street View video, today's video will be on, well, what else? The fixed income markets and the big themes we expect to play out over the next few quarters. But be sure to check out the broader Midyear Outlook piece on LPL.com for the fixed income markets. This week's release of the 2025 Midyear Outlook builds on the themes that we've been talking about all year. A bond market that is dealing with a tug of war between economic data and deficit spending.

Lawrence Gillum (00:49):

Now, like the classic tale of Dr. Jekyll and Mr. Hyde, today's fixed income markets are being pulled in two dramatically different directions. On one side, we have the benevolent Dr. Jekyll, a normal functioning bond market where economic weakness drives rates lower and provides relief to borrowers. On the other side, though lurks the menacing Mr. Hyde. America's mounting federal debt and deficit spending concerns that push rates higher through increased treasury term premiums. So let me start with the deficit concerns. The recent so-called One Big Beautiful Bill Act that was signed into law last week suggests deficits will continue running at 6 to 7% of GDP requiring elevated treasury issuance to bridge the spending gap. Now we have $36 trillion in total debt outstanding growing by approximately $1 trillion every six months. But more concerning than the debt levels themselves, the CBO, the Congressional Budget Office projects, net interest payments on that debt will reach nearly 25% of all federal outlays by 2054 up from 18% currently.

Lawrence Gillum (01:52):

Now this creates two problems. First, rising interest expenses crowd out more productive government spending, and second interest expenses are contractually obligated. So higher interest expenses add to the growing amount of mandatory spending that can't be easily cut from the government's budget. Now, that also means more treasury supply. In a time when foreign investors who own about 30% of U.S. treasuries, they now have more attractive alternatives as global yields have surged to multi-year highs. This supply demand imbalance may mean yields have to stay high to increase demand for all that supply coming to market. And the yield curve reflects this tension. The two-year to 10-year spread sits at just 48 basis points. Well below the historical average of a hundred basis points. We expect further steepening throughout the year, most likely coming from a fall in shorter maturity yields, which suggests limited appeal for extending duration, given the minimal compensation for additional interest rate risk. However, treasury yields remain highly correlated to fed policy expectations with a 0.98 correlation to the expected Fed funds. Trough rate markets

Lawrence Gillum (02:59):

Trough rate markets are currently pricing in around two full rate cuts this year, but with only around a 3.7% trough rate. This is higher than what the Fed has indicated, creating potential for price appreciation. If economic conditions deteriorate more than expected. If the labor market cools significantly or geopolitical events emerge, the Fed may need to cut more aggressively than markets anticipate driving yields lower from current levels. We expect 10-year treasury yields to drift higher in the near term before settling in a four to four and a half percent range by year end. For yields to fall meaningfully below this range, we would need to see economic weakness beyond current expectations. However, despite limited price appreciation expected over the near term, we still think high quality fixed income deserves a spot in portfolios. There's an optionality that you get from bonds that you don't get from cash. Now, while current yields for bonds and cash are similar, bonds offer portfolio protection and potential price appreciation if an unexpected event occurs that would negatively impact the economy that you just don't get from cash.

Lawrence Gillum (04:03):

That said, we don't think right now is a good time to overweight duration or interest rate sensitivity in portfolios. A neutral duration relative to benchmarks is, in our view, still appropriate, and for those investors that want to own bonds for income. As mentioned in our 2025 outlook, the opportunity for income remains robust with the belly of the curve out to five years remaining attractive. The bond markets split personality reflects the ongoing tension between fiscal realities and economic cycles. We expect its volatility to persist until economic data softens significantly allowing markets to price in more aggressive fed easing. Investors should be prepared for continued swings between these opposing forces that define today's fixed income environment. So that's it for now. Thanks for listening, and make sure you check out the full midyear outlook piece on LPL.com. Take care.