Quarterly Market & Performance

The first quarter of 2025 marked a shift in the fixed income market. While the Federal Reserve's actions remain key, the bond market is increasingly shaped by fiscal policies emanating from the White House, particularly those related to trade and tariffs. These policies have taken on a larger role in driving near-term economic growth and inflation expectations, which has added complexity to the Fed’s monetary policy efforts.

The Federal Reserve kept rates steady at 4.5% to start the year, citing ongoing inflationary risks related to geopolitical tensions and trade policies. As Fed Chair Jerome Powell recently noted: "The new administration is in the process of implementing significant policy changes... uncertainty around the changes and their likely effects remains high." One-year inflation expectations have surged from 1.2% before the election to near 3.5%, largely due to uncertainty over policy shifts[1]. This underscores the uphill battle the Fed faces in taming inflation and ultimately lowering rates.

While inflation remains a key concern, the Fed must also weigh broader economic conditions. Its latest projections lowered 2025 GDP growth to 1.7%, down from 2.1% in December. With high inflation expectations, the economy is poised to contract in real terms. Although unemployment remains low, sluggish growth and persistent inflation have raised concerns about stagflation – a scenario where slow economic growth and high inflation occur simultaneously. Given this backdrop, the Fed is likely to keep rates steady in the near term.

Yields across the curve edged slightly lower during the quarter despite the Fed holding the Fed Funds target rate steady, with real returns compressing amidst the economic slowdown. The Bloomberg Aggregate Bond Index returned 2.8% year-to-date, with gains driven by both income and price appreciation. By quarter-end, the Aggregate Bond Index yield stood at 4.6%, reflecting the market’s reassessment of inflation expectations and economic growth prospects[2].

Looking ahead, fiscal and trade policies are exerting a greater influence on the bond market than the Fed’s actions alone. While the Fed’s toolkit remains well-understood, Washington’s policies are less predictable and create added volatility, which could impede the Fed’s ability to use that toolkit to influence interest rates through monetary policy. This highlights the need for a defensive fixed income strategy, as successfully navigating today’s market requires not only monitoring the Fed but also assessing the evolving political landscape.

Correlation Conundrum

Since 2022, bonds have exhibited a higher positive correlation with equities, challenging their traditional role as a portfolio diversifier. Historically, fixed income provided a counterbalance to stock market volatility, but recent trends tell a different story. As illustrated in the following chart, bond and stock prices are moving in the same direction more than at almost any other point in history.

Figure 1: Stocks and Bond Correlation

The correlation between stocks and bonds typically depends on whether markets are driven by growth concerns or inflation fears. When inflation dominates, investors seek inflation-resistant assets, reducing demand for long-duration bonds and driving positive correlation. This dynamic has been on display recently as GDP has struggled to keep pace with the 4.9% CPI growth since 2020[3]. Conversely, from 2000 to 2020, with GDP and inflation both averaging 2.1%, growth concerns kept correlation negative. Post-pandemic inflation, driven by supply shocks and fiscal stimulus, reversed this trend, leading to the highest sustained correlation in decades.

In addition, concerns over the U.S. fiscal outlook have complicated the traditional safe-haven status of Treasury bonds. With deficits already elevated, investors should no longer assume that Treasury yields will fall during economic downturns. Recessions typically reduce tax revenues and increase government spending, which can worsen the deficit and potentially put upward pressure on yields – even in risk-off environments. As a result, Treasuries may be less dependable as a refuge during periods of U.S. economic stress, contributing to the breakdown in their historical diversification benefit.

As a result, the traditional 60/40 (60% stocks, 40% bonds) portfolio has faced scrutiny. If bonds no longer serve as a reliable hedge against equity volatility, the merit to including them in an asset allocation is limited.

While this debate remains unsettled for owners of long-term bonds, our portfolio management decisions that emphasize shorter-duration credit over longer-duration bonds most impacted by this positive stock-bond correlation have rendered this debate largely irrelevant for Kovitz clients. The benefits of our asset allocation decisions within fixed income include:  

·Lower rate sensitivity – Shorter-duration bonds are less sensitive to interest rate fluctuations, reducing overall portfolio swings.

·Higher income generation – Corporate, municipal or asset-backed bonds provide enhanced yields relative to U.S. Treasury bonds that help offset potential price declines.

·Reinvestment flexibility – Recurring proceeds from individual bond portfolios allow for natural capital deployment into equities when market stress creates attractive opportunities.

The debate over whether the 60/40 portfolio is broken overlooks an important truth: it's not just about the cards you're dealt, but how you play the hand. While traditional stock-bond relationships have shifted in the overall bond market that is dominated by longer-duration bonds, bonds still offer value when positioned thoughtfully. Rather than relying on outdated assumptions of negative stock-bond correlation, our focus on shorter-duration credit helps manage rate risk, generate income, and maintain reinvestment flexibility.

Conclusion

Looking ahead, the direction of the bond market remains uncertain due to changing government policies, evolving inflation trends, and a mixed economic outlook. While the Federal Reserve will always have significant influence on the bond market, market volatility is now increasingly influenced by fiscal policy decisions from Washington. In this environment, maintaining a flexible and defensive fixed income strategy is critical.

The traditional relationship between stocks and bonds has shifted, but fixed income remains essential for capital preservation and stability in a well-balanced portfolio. By emphasizing shorter-duration credit, we can mitigate rate sensitivity, enhance income, and preserve reinvestment flexibility – three key elements in navigating an inflation-driven market. As policy-driven volatility persists, an adaptive and deliberate approach to bond allocations remains the best path forward.

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[1]Bloomberg US Breakeven 1 Year. Rate measured by subtracting the real yield of the inflation linked securities from the nominal yield of Treasury bonds.

[2] Bloomberg US Aggregate Bond Index. Yield measured as yield-to-worst.

[3] US Consumer Price Index Urban Consumers Seasonally Adjusted.

DISCLOSURES

Kovitz Investment Group Partners, LLC (“Kovitz”) is an investment adviser registered with the Securities and Exchange Commission. The information and opinions expressed in this publication are not intended to constitute a recommendation to buy or sell any security or to offer advisory services by Kovitz. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to participate in any trading strategy, and should not be relied on for accounting, tax, or legal advice. This report should only be considered as a tool in any investment decision matrix and should not be used by itself to make investment decisions.

Opinions expressed are only our current opinions or our opinions on the posting date. Any graphs, data, or information in this publication are considered reliably sourced, but no representation is made that it is accurate or complete and should not be relied upon as such. This information is subject to change without notice at any time, based on market and other conditions. Past performance is not indicative of future results, which may vary.