The balancing act continues

The Treasury market has been caught in a narrow range lately, confined by data portraying a resilient economy and some signs of tariff inflation passthrough that grabs the attention of a patient Fed. Current expectations are that the US economy continues to expand, albeit at diminished underlying rates as consumer spending growth has slowed, residential housing activity remains weak and business investment growth is modest.

Recession risks receding

The front running of tariffs that boosted imports and inventories in Q1 and pushed annualized GDP growth below zero has partially reversed in Q2 GDP data, boosting the overall level of GDP growth to 3.0%. That said, the underlying pace of domestic growth excluding the tariff-induced volatility in inventories and trade fell to just 1.1%, its lowest level since late 2022.

Looking forward, the One Big Beautiful Bill should provide modest economic stimulus given permanent extension of tax rates, moderate tax cuts on tips and social security and pro-investment-related corporate expensing provisions. These stimulative forces may counter the negative growth effect of a nearly 7- to 10-times increase in the weighted average tariff on goods imported into the US this year. Ongoing negotiations and agreements have helped soften but not eliminate concerns about long-term tariff effects which should play out over quarters and years. For now, the expected recession risk that surged last Spring has receded, even as growth seems to have downshifted.

Hold or ease? That is the question

On the monetary policy front, the Fed remains on watch for tariff-related inflation. In fact, the most recent CPI data suggests some passthrough is occurring. But the Fed is not considering raising target interest rates. Rather, the FOMC is effectively debating how long to hold steady while the tariff effect unfolds before they ease to counter a decelerating economy. Meanwhile, the political pressure on the Fed drives headlines and may be seeping into policymakers’ thinking, as Trump repeatedly threatens then backs away from moving to fire Chair Powell.

Expectation that the Fed will soon resume their easing path after a long pause continues to support risk-asset performance, which in turn supports growth via positive wealth effects. When growth slows enough to warrant interest rate cuts, the risk-on rally in broader financial markets may already be off.

Policy abroad

Looking globally, the ECB easing path is on pause with the main financing rate at 2.15% and may be nearing its trough, while the BOJ faces building inflation pressures and a potential fiscal expansion after electoral surprises there. China continues to post strong growth, albeit with deflationary tendencies. Oil markets appear well supplied globally. Wars persist in hot spots unfortunately, but still with little financial market impact. “What could possibly go wrong” remains a common theme, but the global environment is supportive of eventual declines in US interest rates.

Factors balance out

With the 10-year US Treasury yield at about the middle of its recent 4.20% to 4.60% range, the Duration Committee recently elected to maintain a slight lean long position. This call reflects expectations of some softening in US data—likely in job creation—that will prompt the Fed to provide moderate easing later this year. On the other hand, the long position is limited by fading recession risk, stimulative fiscal policy, persistently large Treasury borrowing and stimulative deregulation in D.C.