Fixed income outlook: Bond investing in a new Fed regime

For much of recent history, fixed income investors have operated within a familiar policy framework. Central banks anchored markets, forward guidance often mattered more than the data itself and understanding the Federal Reserve's reaction function became almost as important as understanding economic fundamentals.

We believe that framework is beginning to give way to a new regime, with the market reaction to the July 29 FOMC meeting and Chairman Warsh’s press conference potentially serving as a sign of what may be in the offing.

Economic growth has remained resilient, supported by investment in artificial intelligence (AI), healthy corporate balance sheets and robust capital spending. But growth is becoming more narrowly driven, policymakers face more complex trade-offs, and the Federal Reserve is entering a new chapter under new leadership. As central bank communication becomes less prescriptive, investors may need to spend less time anticipating policy moves and more time assessing the underlying economic and market forces shaping investment outcomes.

Today's yields continue to make a compelling case for fixed income. What has changed is not the opportunity, but how investors should think about capturing it.

The margin for error has narrowed. Investment outcomes depend less on how much risk investors take and more on where, and how selectively, they choose to take it. In this environment, judgment becomes increasingly valuable.

The path of the U.S. economy and markets has been strikingly uneven over the past year, but despite the volatility, the underlying picture remains broadly constructive. It is easy to forget that in early 2025 markets priced nearly 70% odds of a recession by year-end.¹ Instead, recession fears faded and economic activity proved far more resilient than expected.

A key driver of that resilience has been the AI investment boom. Hyper-scaler capital expenditures have grown nearly 80% year over year, fueling economic growth, corporate earnings and market returns.² Nonresidential investment has expanded at an exceptional pace, helping support GDP growth even as higher interest rates continued to weigh on housing and other rate-sensitive sectors.

The long-term implications of AI remain powerful, but the near-term investment story is becoming more nuanced. The level of spending can remain high even as the growth rate cools, and markets tend to price that shift before the data confirms it. AI-driven disruption is also starting a much longer process of labor reallocation that is likely to create winners and losers across industries, even as headline economic data remains healthy.

Recent employment reports have been encouraging, but much of the hiring strength remains concentrated in a handful of sectors, while signs of softness are beginning to emerge elsewhere. At the same time, inflation has remained elevated due in part to the energy shock associated with the conflict in Iran. While both labor market and inflation pressures warrant respect, we believe they are likely to moderate over time.

Growth remains positive, but the drivers of growth, earnings and employment are becoming more concentrated. Markets have benefited enormously from a narrow set of powerful themes, particularly around AI investment, but the next phase is likely to require greater precision in how risk is allocated and where opportunities are sourced.

These crosscurrents create a difficult backdrop for policymakers, which is why we are encouraged by recent developments at the Federal Reserve. In our view, the arrival of Chairman Kevin Warsh signals the beginning of a new era in monetary policymaking.

We expect less reliance on traditional forward guidance and a reduced emphasis on strict “data dependence”. Rather than reacting solely to backward-looking indicators, policymakers are likely to place greater emphasis on where inflation, employment and growth are headed, using broader analytical frameworks and real-time information to assess the economy.

Importantly, we also believe the Fed will utilize a wider panoply of policy tools than investors have grown accustomed to over the past decade. That may include greater attention to the balance sheet, liquidity conditions, money supply dynamics and longer-term interest rates, rather than relying predominantly on the overnight fed funds rate as the primary mechanism for influencing economic activity.

We are also encouraged by efforts to incorporate perspectives from across the public and private sectors. In a rapidly evolving economy, a more modern policy framework requires a wider range of expertise, data and analysis.

While this approach may imply less certainty around the precise path of policy, we believe it can improve the Fed's ability to respond to a rapidly changing economy and build confidence in its long-term objectives around inflation and employment.

For investors, this reinforces the importance of staying focused on income rather than trying to predict every move in rates. We remain respectful of the possibility that the Fed could tighten further if inflation proves persistent, but additional hikes are not a foregone conclusion. We continue to favor an income-first approach rather than taking large directional duration positions until the data more clearly validates a turn.

Today's yield levels provide a meaningful cushion against volatility and remain one of the most compelling features of the fixed income market. Some investors may view this new policy framework as a source of greater uncertainty. We see it somewhat differently. Periods of uncertainty and elevated volatility can create opportunities, particularly when markets overreact to changing expectations. In that environment, we continue to see value in selectively selling volatility when opportunities present themselves, while remaining focused on resilient income streams and long-term return potential.

At the same time, we believe investors should avoid relying on broad market exposures alone. Risk premia across many markets have compressed meaningfully, and opportunities are becoming more selective.

In our view, this environment favors active decision-making, flexible portfolio construction and a willingness to look beyond traditional benchmark exposures. Global fixed income markets continue to offer a broad opportunity set across sectors, regions and asset types, creating opportunities to build diversified streams of income and pursue attractive risk-adjusted outcomes.

The bottom line is that growth remains resilient, but the market environment is becoming more complex. We believe investors should stay invested, focus on income, remain flexible and be increasingly deliberate about where risk is taken. As we move into the second half of the year, it is time to get more serious about portfolio construction.

That is the perspective we bring to this quarter's Fixed Income Outlook. Read the full report for insights from across markets to examine the forces shaping today’s fixed income landscape and explain how we are positioning portfolios for a market defined by new realities rather than old assumptions.