Bond yields have fallen over the past few months as the prospect of slower U.S. economic growth has offset stubbornly high inflation. While that sounds a lot like "stagflation," it's not at the level seen in the 1970s. The economy is still growing, and inflation isn't exceptionally high or rising rapidly, as it was then. However, the persistence of this combination and uncertain outlook for policy keeps us cautious in our approach to the bond market. While we see value in yields at current levels, we don't think this is the time to take risk in duration—a measure of sensitivity to interest rate changes—or credit quality.

Recent economic data suggest that the pace of economic growth is set to slow. As the first quarter comes to a close, it appears that gross domestic product (GDP) growth in 2025 will likely decline from the 3% annualized pace of the past three years. The prospect of a trade war and ongoing high prices are weighing on consumer spending and business investment.

Given the pessimistic outlook, inflation-adjusted (or "real") consumer spending has been tepid over the past few months despite strong real income growth. The rebound in February just barely made up for the weather-related drop in January, leaving spending flat in the first two months of the year.

Worries about the job market are also weighing on consumers. The layoffs and cutbacks in the federal government are likely to have a longer-lasting ripple effect. In addition to the decline in government jobs, contractors and workers at the state and local level may feel the impact as funding is cut.

So far, the labor market is holding steady, but the pace of hiring has slowed. In the private sector, layoffs have begun to pick up.

Policy uncertainty is weighing on business investment, as well. Companies surveyed by the regional Federal Reserve banks—such as the Dallas Fed survey represented in the chart below—have cited the potential for a supply shock due to tariffs as a reason to slow spending and hiring. Higher input costs and concerns about declining demand due to retaliation are likely to limit investment.

The risk is that the economy will slow to "stall speed," which makes it vulnerable to falling into recession. Economies are dynamic. Once growth stalls out, a drop in activity can develop even without outside shocks. The New York Federal Reserve's recession probability model for the next 12 months is up to 27%, which is not historically high. But the longer that growth remains tepid the more the risk will rise.

Meanwhile, inflation also has been steady. It has been holding in the vicinity of 2.5% to 3.0% by most measures for much of the past year. The price index for Personal Consumption Expenditures (PCE) has been near an annualized pace of 2.5% for the past year. Excluding food and energy, the index is stubbornly holding at around 2.8% on a year-over-year basis.

With tariffs now a reality, prices on some imported goods are set to rise. A one-time increase can probably be absorbed by the economy, but if there is a series of tariffs affecting goods prices, then higher inflation could take hold. Given the uncertainty about how long tariffs might last, forecasting inflation is difficult.

The Federal Reserve is in a tight spot. At its latest meeting, the Fed's quarterly Summary of Economic Projections (SEP) indicated policymakers leaned toward cutting the federal funds rate. However, there is a wide dispersion among members about the timing and magnitude of cuts. Moreover, they keep pushing rate cuts into the future, given that inflation remains above the Fed's 2% target. We are still expecting one to two rate cuts in 2025, largely due to our expectation that the economy will slow and the unemployment rate will increase later in the year. However, for now Fed policy is likely on hold until the third or fourth quarter.

Since the end of last year, we have advocated a cautious approach to the bond market. We aren't prepared to increase exposure to either duration or credit risk given the current economic outlook.

Volatility is likely to remain elevated for at least a few more months until the impact of tariff and fiscal policies are visible. In addition, Congress must address the need to lift the debt ceiling and pass a budget. In the contentious atmosphere in Washington, it's not at all clear how the process will play out. Against that background, 10-year Treasury yields could rise as high as 4.75% in the near term, but in the longer term, 10-year yields could fall to 3.75% if the economy falters. The yield curve is currently positively sloped—meaning short-term yields are lower than longer-term yields—but could invert if recession risk rises.

With that range in mind, we believe a bond portfolio of intermediate duration concentrated in high-credit-quality bonds makes sense for many investors. The benchmark for the bond market we look to is the Bloomberg US Aggregate Bond Index, which tracks the performance of a broad swath of investment-grade bonds including Treasuries, other government-backed securities, and corporate bonds. It has an average duration of about 6.1 years with a current yield-to-worst (the lowest possible yield that can be received on a callable bond, assuming it doesn't default—of 4.6%. We view that as a reasonable starting point for investors building bond portfolios. It provides enough duration exposure in the event that yields fall but is low enough to mitigate some of the potential volatility if yields rebound.

We also continue to favor focusing the majority of holdings on higher-credit-quality bonds due to the potential for an economic slowdown. Lower-credit-quality bonds, such as high-yield bonds, are more susceptible to rising defaults in a weak economy. That market is beginning to show signs of concern, with yield spreads relative to Treasuries of comparable maturity widening. However, the spread is low relative to the longer-term average. We don't think it makes sense to take too much credit risk without getting a higher yield.

All in all, we are looking to move to higher ground amid the potential flood of policy uncertainty.