**Inflation Moderates, But Fed Remains Cautious**
Despite a seasonal bump at the start of the year, inflation has eased in recent months, falling in line with the broader trend observed over the past twelve months. Both core CPI and core PCE, the Federal Reserve’s preferred measure of inflation, have declined on a year-over-year basis to levels not seen since 2021. This suggests that the Fed’s aggressive rate-hiking cycle has had some success in curbing inflationary pressures.
However, Fed officials remain cautious, emphasizing the need for patience and data dependency in their decision-making. They warn against easing policy too soon, fearing that it could reignite inflationary pressures. As a result, the prospect of a potential rate hike has gained traction, causing an early-quarter surge in U.S. Treasury yields.
**Labor Market Weakens**
While inflation has garnered much attention, the labor market has quietly weakened in recent months. Unemployment has risen over 50 basis points from cycle lows to 4.0%, and job openings, a key measure of labor demand, have fallen to their lowest level in three years. Wage gains, a hallmark of pandemic-related dislocations in labor markets, have also slowed.
**Market Performance**
Equity markets have seemingly shrugged off the potential downside, posting a 4.3% gain in the second quarter. However, this gain has been driven largely by the top cohort of names in the Index, with the equal-weighted version down 2.6%. Fixed income returns have been more subdued, with the Bloomberg U.S. Aggregate Bond Index up just 0.1% in the quarter.
**Outlook**
The Fed’s commitment to avoiding a 1970s-style stagflation increases the likelihood that it will keep rates too high for too long, ultimately compounding the already evident uptick in unemployment. This potential stress, coupled with the Fed’s resolute stance, is expected to elicit a more forceful and abrupt shift in monetary policy than what is currently priced into markets.
As a result, the duration position remains 0.8 years long versus the Index, with a continued emphasis on front-end and intermediate yields. Sector positioning is informed by a recognition that valuations in certain markets do not reflect the prospective risks of a slowing economy.
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