Keeping it real: The Fed maintains the most practical course

For a data-driven Fed, these could be construed as perilous times. Sentiment-driven data have indicated signs of brewing weakness but the hard indicators upon which the Fed bases its decisions have proven resilient. Furthermore, policy uncertainty remains a wildcard as the Fed – and the market – seek to determine whether the putatively pro-growth aspects of the Trump agenda can outweigh arguably growth-negative tariffs.

The economic and policy uncertainty has likely bought the Fed time to observe additional developments with respect to growth and the labor market, consumer prices, and mounting geopolitical tensions. This week’s is the type of realistic Fed statement that the market – and public officials – will have to live with as it represents the most practical policy path given especially complex circumstances. Accordingly, we believe it’s prudent to maintain the investment positioning that has guided us for much of the year: Be cautious toward the riskiest assets in a slowing economy; it’s too early to lean into U.S. duration with the tariff-driven inflation outlook far from settled; and investors should capitalize on diverging economies and policy paths to appropriately source opportunities for diversification and excess return where conditions present themselves.

Squaring the data

For many, the first question that arises when reviewing the Fed’s statement is how to square maintaining the call for two 25 basis point (bps) cuts this year while raising the expectations for year-end headline and core inflation to 3.0% and 3.1%, respectively, up from March’s 2.7% and 2.8% projections. Adding kindling to the hawkish argument is 2026 inflation, for both measures, coming in at 2.4% versus March’s 2.2% and still above the central bank’s 2.0% objective.

The answer, in our view, is that although, at 4.5%, the fed funds rate is restrictive when measured against a core personal consumption index of 2.5%, hard economic data have shown scant signs of imminent weakening. Nonfarm payroll changes – even with a notable downward revision of March and April numbers – remains within the range associated with economic growth, and, while off its post-pandemic peak, at 3.9%, year-over year hourly earnings growth sits well above its average for the decade preceding the COVID-19 shutdowns. Signs of softness in both initial jobless claims and job openings merit monitoring, but at this point they haven’t reached a level that would compel the Fed to act.

The argument for keeping only two rate cuts on the table for 2025 is reflected in the Fed’s upward inflation revisions. In fact, Chairman Powell spent time in his press conference seemingly prepping the market, consumers and officials for a wave of higher prices in coming months. The shock absorber provided by the pre-Liberation Day inventory build-up is being depleted, meaning the initial wave of tariff pain could hit consumers’ wallets just in time for the back-to-school rush.

The conundrum that the Fed seeks to avoid is a stagflationary environment that creates acute tension between the pillars of the central bank’s dual mandate: price stability and low unemployment. Without higher prices potentially being a Los Angeles bound freighter away (and to this we can add the possibility of energy price shocks due to developments in the Middle East) Chairman Powell and company may have been more comfortable in pulling forward rate cuts. But with the range of outcomes wide, patience will likely serve the Fed well for the next few months. The central bank is quite mindful of its botched 2022 transitory call which is likely why, even as it lowered its 2025 and 2026 growth estimates and raised unemployment projections, it coalesced around the view that it’s too soon to resume monetary easing.

Notably, the Fed’s latest “dot plot” projections indicate an additional rate cut next year. While this is less aggressive than the March forecast, we interpret it more as a reflection of elevated policy uncertainty than a signal about the next Fed Chair. That said, with President Trump expected to nominate a successor to Mr. Powell before his term ends in 2026, speculation is mounting. All we can be certain of is the candidate would likely be seen as more aligned with President Trump’s preference for more accommodative monetary policy. Markets, however, could take a circumspect view of this, mindful of the importance of central bank independence.

Much to watch

In coming months, the market will need to continue to decipher notoriously difficult to predict economic developments and seek greater visibility into President Trump’s ambitious economic agenda. While the market has embraced the view that we are behind April’s worst-case tariff level scenario, many of the delays of previously announced duties levied against major trading partners are set to expire over the summer.

The market must also weigh the benefits and risks of the Big Beautiful Bill presently before congress. Investors have largely looked forward to the deregulatory component of President Trump’s agenda, but recognize that in addition to tariffs, fiscal profligacy and too-stringent immigration policies can be headwinds to growth.

Maintaining a cautious – and global – stance

Macroeconomic tensions and policy uncertainty are hardly conducive environments for aggressive risk taking. Consequently, we still believe that investors should prioritize resilience and diversification. This less-dovish-than-originally-thought Fed statement reinforces our stance that geographical diversification is an opportunity for investors, given that several advanced economies have continued to cut rates. Additional cuts in the face of flagging growth would create opportunities for capital appreciation within the bond sleeve of a broader portfolio, potentially diminishing headwinds for more economically sensitive assets. And as was illustrated in April, unlike during typical periods of rising macro and geopolitical volatility, there is no guarantee that U.S. denominated assets will be beneficiaries of the flight to safety as investors increasingly seek to diversify into regions like Germany.

Within the U.S., a still uncertain inflation outlook means it’s not yet time to extend duration. The higher prices that Chairman Powell believes may soon wash up on U.S. shores could lead to curve steeping, driven by mid-to longer-dated yields. But with future hikes not even mentioned, we believe shorter-dated Treasuries and higher-quality corporate bonds within the 1-to-3-year range offer attractive risk-adjusted returns in a very fluid environment.

IMPORTANT INFORMATION

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.

Volatility measures risk using the dispersion of returns for a given investment.