Fixed Income Update: Higher for longer remains our near-term outlook

From the Office of the CIO

Rod Olea, Managing Director, Head of Fixed Income
Tobias Tolino, Senior Vice President, Fixed Income Portfolio Manager
Adam Gorlyn, Senior Vice President, Investment Strategy & Communications

A central theme of our 2025 Investment Outlook was the notion that U.S. interest rates will remain higher for longer. This deviation from past economic cycles reflects a mix of resilient U.S. economic growth, sticky inflation and cautious Fed policy. While additional cuts to the federal funds rate are anticipated in 2025, the U.S. Federal Reserve Fed  made it clear they are not inclined to reduce rates in the immediate future. In addition, investor expectations continue to moderate regarding the degree and pace of potential easing. Our view is that investors can benefit in this higher-rate environment by harvesting attractive yields from high-quality fixed income securities without taking undue interest rate and credit risk.

How did we get here?

We are of the view that persistent U.S. inflationary pressure is a result of government-implemented, large-scale fiscal stimulus measures enacted to support economic activity during the pandemic. As the economy slowly reopened, pent-up demand surged as consumers were able and ready to spend, all the while supply chain disruptions and geopolitical tensions pushed the prices of goods higher.

Despite an aggressive series of interest rate hikes by the Fed in 2022 and 2023, inflation has proven to be resilient, and gains made toward achieving the Fed’s 2% inflation target has remained elusive since May 2024 (Figure 1). As of this writing, forward-looking economic projections suggest that the Fed’s 2% target will not materialize (in Core CPI data) until 2026, at the earliest.

Figure 1: Core CPI, Trailing 5-Year

Source: Citizens Wealth Management via National Bureau of Labor Statistics as of 1/31/2025

Why we’ll stay here… at least in the near term

The Fed kept the federal funds rate steady at the 4.25%-4.5% target range during its most recent meeting in January 2025, pausing its rate-cutting cycle after three consecutive reductions in 2024. Federal Reserve Chair Jerome Powell indicated in his January 2025 testimony to the Senate Banking Committee, “With our policy stance now significantly less restrictive than it had been, and the economy remaining strong, we do not need to be in a hurry to adjust our policy stance.” He continued, “We know that reducing policy restraint too fast or too much could hinder progress on inflation.” 

As we highlighted in our 2025 Outlook, we are of the view that the U.S. economy will prove to remain resilient. Supported by consumer consumption amidst a relatively healthy job market, we believe we are poised to see above trend U.S. Gross Domestic Product (Figure 2), enabling the Fed to be comfortable with remaining on hold while meeting its dual mandate of promoting maximum employment and stable prices.

Figure 2: Growth of GDP and Personal Consumption Expenditures (annualized)

The U.S. unemployment rate continues to hover near lows experienced sparingly over the past 55 years (Figure 3). In addition, as wage growth has begun to slow, inflationary concerns associated with maintaining full employment have waned. Economic growth combined with reasonably positive employment trends would diminish recessionary concerns, fostering an environment wherein higher rates would not be viewed as restrictive on the broader economy.

Figure 3: U.S. Unemployment Rate

Additional considerations

The U.S. growth picture alone is not the driver of inflationary trends. Regional conflicts around the globe continue to impact costs of energy, food and raw materials forcing corporations to diversify sources of production and reduce dependency on certain countries. More recently, tariff proposals emanating from Washington have further impacted pricing as producers attempt to acquire raw materials in anticipation of added trade costs.

High absolute levels of U.S. government debt are also supportive of our thesis. The U.S. federal deficit has increased significantly over the past eight years, due to stimulus measures and fiscal policy decisions from  prior administrations. As lower yielding U.S. Treasury debt matures, the cost of servicing new debt significantly increases in a higher rate environment, putting additional pressure on public finances. In fact, approximately $7.5 trillion of  U.S. Treasury obligations are set to mature through calendar year end 2027.  Reissuing this debt today would come at a meaningfully higher cost than the average 2.50% coupon of maturing issues.

Potentially adding to the domestic debt load is the anticipated extension of tax cuts passed during the first Trump administration. This could create larger than anticipated fiscal deficits putting  additional upward pressure on interest rates, as investors would demand additional compensation for the assumed risks associated with owning the debt. Fiscal budgetary deficits over 5% of GDP are considered by economists to be unsustainable. As of January 31, 2025, the U.S. deficit as a percentage of GDP had broached 7.2%, capturing the attention of both the White House and Congress as they tackle new policy priorities. While the Fed doesn’t control fiscal policy, they appreciate how it may impact the broader economy and could keep interest rates elevated to instill some semblance of fiscal discipline.

Finally, investors have come to view that the fed is poised to remain on pause.  Throughout the current economic cycle, market participants have been actively repositioning ahead of monetary policy adjustments. Unlike previous anticipated changes to the fed funds rate, the current two-year U.S. Treasury, which is strong barometer of future Fed policy, is now reflecting a low probability of near-term fed rate cuts (Figure 4). This is a stark reversal from Q1 2024, when investors were forecasting 100 basis points of cuts to the federal funds rate.

Figure 4: Differential of Fed Funds Rate to 2-Year U.S. Treasury

Looking further ahead in 2025, the International Monetary Fund has estimated that U.S. GDP will grow at a rate of 2.7 percent. The Fixed Income team is of the view that this figure may be slightly too optimistic, given the emphasis from the Trump administration on deep spending cuts that may drag down the government sector’s contribution to GDP.  We anticipate that a downsizing of the U.S. government workforce will appear in employment data in due course.  Other Trump administration priorities of regulatory reform, tariffs, immigration, and tax cut legislation (just to name a few) will undoubtedly impact the economy over the coming quarters. However, the ultimate timing of when these policy changes would be felt in the economy is difficult to precisely forecast.

How should U.S. fixed-income portfolios be positioned?

Given the aforementioned backdrop, we anticipate a U.S. fixed income environment wherein short-term rates are poised to remain anchored until the Fed has further clarity into the impact of new policies on economic activity. In addition, intermediate and longer-term interest rates are likely to stay elevated and may exhibit additional volatility as investors react to economic data, particularly from headlines of larger than anticipated fiscal deficits. Hence, we retain a bias toward shorter-dated, high-quality debt securities as attractive yield is available on the front end of the curve, enabling investors to collect high current income without having to take significant interest rate risk.

Investment grade credit

Corporate bond yields remain historically tight relative to U.S. Treasuries and do not offer significant yield enhancement for investors. Nevertheless, high-quality, investment-grade corporates provide attractive levels of absolute income as investors continue to exhibit strong demand for new issuance. While the credit cycle and broader economy remain favorable for corporate debt, we cannot rule out the potential for spread widening in the later part of the year. At the sector level we continue to favor bank issuers and select financials as they are poised to benefit from deregulation, as well as a steeper yield curve. Conversely, we continue to avoid public utilities and issuers with exposure to office real estate.

Municipals

Despite some headline risk, municipal debt has experienced a positive start to the year.  Heavier than usual new issue flow was easily absorbed by market participants reaffirming the resilience of the asset class.  As discussed in our 2025 Outlook, our recommendation remains prioritizing the debt of issuers with dedicated revenue streams.  Potential changes in state and local government funding sources have reduced our sentiment toward sectors that are reliant on federal subsidies, such as hospitals, higher education, and transportation.  In addition, state and local government debt may face potential risks due to policy discussions around deficit reductions. This may include the tax-exempt status of municipal debt, caps on state and local tax deductions, infrastructure spending, and transfer payments from the federal government to states.  Finally, although current municipal valuations may appear rich on a historical basis, taxable equivalent yields still provide opportunity for income focused investors in high tax brackets.

Conclusion

The higher for longer interest rate environment appears to be in place for the near term. We believe this has created an opportunity for investors to collect high current income without having to take undue interest rate risk in their fixed income portfolios. We favor government and higher quality corporate issuers, as the additional yield offered from lower rated debt does not fully compensate investors for potential downside risk. As always, we continue to monitor developments that may impact portfolio positioning and will proactively communicate changes to our outlook.

About the authors

Rod Olea joined Citizens Private Wealth in 2023 and serves as the Head of Fixed Income. He leads the firm’s investment management capabilities for institutional and ultra-high net worth (UHNW) clients. He directs a team of fixed income portfolio managers, credit analysts and traders to provide a disciplined investment process and strategies for business and private bank clients. Prior to joining the firm, Rod was managing director and fixed income portfolio manager for First Republic Investment Management (First Republic Bank) between 2010-2023. There, he directed fixed-income strategy and management for institutional, UHNW, and for the clients of his Wealth Manager colleagues. Prior to First Republic, Rod was director of fixed income for City National Asset Management at City National Bank from 2004-2010. Rod received his B.A. in Economics from University of California, Los Angeles.

Toby Tolino joined Citizens Private Wealth in 2019, via merger with Richter Bober Asset Management, as a fixed income portfolio manager, specializing in municipal strategies. Toby has more than 20 years of experience working with ultra-high net worth, high-net worth, and institutional clients. He is responsible for working with clients to develop and implement tailored investment solutions that align with their overall wealth objectives, while providing ongoing oversight and the highest level of client service.

Adam Gorlyn Senior Vice President, is a Senior Investment Strategist and Director of Communications for the Office of the CIO at Citizens Private Wealth. He brings over 15 years of expertise within institutional investment management with a focus on fixed income and multi-asset strategies. Throughout his career, Mr. Gorlyn held senior leadership positions at leading investment institutions including Franklin Templeton Investments and Citigroup Asset Management. Most recently, Mr. Gorlyn was responsible for the design and implementation of Franklin Templeton’s model portfolio business setting asset allocation as well as investment process and strategy. Mr. Gorlyn holds a B.A. from Rutgers College in both Political Science and Psychology. In addition, he completed an MBA with a concentration in Finance from the Gabelli Business School at Fordham University. He holds Series 7 and 66 securities licenses.