Treasury yields have been falling for six consecutive weeks, with 10-year yields hitting the lowest level since December. Yet consumer surveys still indicate that inflation expectations are high and the Federal Reserve has indicated it is keeping its policy on hold indefinitely. That isn't the typical backdrop for declining bond yields.

What's happening? To reconcile the market move with the data, we look to expectations. As we've pointed out several times, in general, government policies that impose trade barriers and limit immigration have the potential to raise inflation in the short run and slow growth in the long run. It looks like the bond market has decided to bypass short-term inflation concerns and focus on the long-term prospects. As a result, the yield curve has inverted again with the fed funds rate higher than yields for all maturities.

So far, the economic data aren't pointing to recession, but there are warning signs of a growth slowdown. Fourth-quarter gross domestic (GDP) growth came in at a healthy 2.3% pace, driven primarily by consumer spending. However, the early data for this year suggest a slowdown is in the making.

The various Federal Reserve Bank surveys have shown more caution among businesses. The Philadelphia Federal Reserve's Manufacturing Business Outlook Survey results, shown in the chart below, are consistent with other reserve bank findings: New orders and hiring are down while prices are up. Comments from businesses across the country focus on the uncertainty surrounding tariffs and the potential negative impact on orders.

In addition, real personal spending showed a steep drop in January after a year of monthly gains. Lousy weather in much of the country may have contributed to the decline, but it was much weaker than expected and is an indicator that bears watching.

Perhaps all of the news about mass layoffs in the federal government and cutbacks in services combined with the prospects of a trade war have soured the outlook for consumers. We always go by the mantra that you should watch what consumers do and not what they say. Consequently, it will take more evidence of a shift in consumer behavior to know whether the drop in sentiment is translating into a sustained drop in spending.

The January unemployment report should provide some insight. To date, the job market has remained healthy, with the unemployment rate remaining low near 4% and job growth surprising on the upside. Under the surface, however, job openings and the pace of hiring have slowed. Those trends have been offset by a relatively sluggish pace of layoffs. The federal government layoffs won't likely show up in the data right away, but it may be hanging over the market and consumer sentiment. It's worth noting that for every federal government worker, there are an estimated two contractors in the labor market. Contractors often are the first to be laid off. An uptick in weekly initial jobless claims during the week ending February 22nd may just be a fluke but if the trend continues, it would be a signal of a slowdown.

While the drop in yields points to the market's focus on waning growth prospects, it is worth noting that inflation is still above the Fed's 2% target. The recent Personal Consumption Expenditures (PCE) price index report for January indicated some easing in pressures, but at 2.5% for overall PCE and 2.6% for core PCE (excluding volatile food and energy prices), inflation is still too high for the Fed to consider another rate cut.

Moreover, with the tariffs on goods from Mexico, China, and Canada, inflation risk is likely to revive. These countries are major U.S. trading partners. Consequently, there is a lot at stake for the economy.

There is a lot at stake for the Federal Reserve, as well. Inflation is too high and the outlook too uncertain for easing policy, but slower growth longer term could warrant it. No one at the Fed is arguing for it to abandon the 2% inflation target. It has been in place since the 1990s and is the standard for most major developed market central banks. With so many factors at odds, all the Fed can do is wait to see what happens next.

Meanwhile, at least half of all consumers are worried about rising prices (expectations tend to diverge along political party lines). Egg prices, which have been a major reason behind consumer inflation concerns, have yet to fall (the average price for a dozen Grade A large eggs was $4.95 in January, compared with $2.04 in August 2023, according to the Bureau of Labor Statistics). With the agencies reporting on bird flu now limited in their ability to report due to federal job cuts, we don't know what to expect—yet another source of uncertainty for consumers.

We are in the middle of a lot of major economic changes. So many policies are up in the air—trade, tax, immigration, and government spending, to name a few. It's not surprising that there has been heightened volatility in markets.

We continue to suggest taking a cautious approach to fixed income investments. Despite the drop in yields, we are reluctant to suggest extending duration beyond benchmark levels. The tug-of-war between inflation and growth is not over and may mean yields bounce around for the next few months.

We also continue to favor staying up in credit quality. Credit spreads are near historically tight levels, which doesn't leave much extra yield for taking risk by going lower in credit quality. It's especially important to remember the value of liquidity in this kind of market. When stress emerges, the lower-credit-quality investments tend to become the most illiquid as everyone rushes for the door at the same time. Liquidity is underrated as an investing factor, in our opinion.

Stay diversified. It may seem like something we always say, but it's the best defense against the unknown. The current environment is one of the most uncertain we've seen. It seems like the markets are only beginning to react to the changes that are taking place. There could be a lot more volatility ahead. The bond market often leads other markets, and the steep drop in yields over the past six weeks appears to be a signal that investors are seeking safety.