What does this mean for fixed income investors? Initially, domestic bond yields shot up and the yield curve flattened, as market-implied measures of inflation spiked and expectations of further Federal Reserve cuts disappeared. Credit spreads widened. The option-adjusted spread on the investment-grade bond index jumped from 78 basis points at the beginning of the quarter to 89 at quarter-end. The 30-year agency MBS basis widened from 87 basis points to 106 over the same period.  Both asset classes now offer more attractive entry points. Treasury yields rose across the curve during the quarter, led by the 2-year and 5-year maturities. The market is expecting the Fed to remain firmly on hold for the remainder of 2026.

The broader economic spillover is meaningful. An inflationary shock crimps the consumer. Higher gasoline and transportation costs lead to rising prices for food and manufacturing inputs. Rising long-dated yields feed directly into higher costs of home ownership via elevated mortgage rates. This leads to demand destruction across the economy. Add to this, there are other areas of concern unrelated to the Middle East, namely the magnitude of defaults and redemptions expected across the private credit asset class. The economic outlook is now as cloudy as it has been since COVID. However, there is a silver lining for investors. We are entering this period of uncertainty from a point of relative strength: 2-3% annualized GDP growth, sub-3% inflation, healthy earnings, strong corporate balance sheets, and monetary and fiscal stimulus. During turbulent times, disciplined risk management remains the anchor of our investment strategy.