You can’t ignore the massive market selloff last week, even if cash pools and short-term fixed income portfolios escaped the worst. Equity markets bore the brunt, losing 10-15%. (That selloff continued this morning.) By contrast the fixed income markets seemed a calm and sheltered place. Yes, bond yields fell but the change in short term Treasuries in the week was less than 20 basis points. That happens a couple of times a year. Even the so-called flight to quality, where investors seek short term Treasuries at any price, was muted: The three-month Treasury bill fell only four basis points in yield  in the week.

This is not to say it will not matter for bond investors. effects are down the road and this is the right time to prepare.

Overall, the markets were a picture of contrasts:

• The widely followed Vix index that tracks equity market volatility rose to the second highest level in in its 40 year history (the highest was at the onset of the Covid pandemic). The MOVE Index of bond market volatility rose as well but remained far below its peak in 2008.

• Corporate bond spreads expanded as investors demanded higher premiums to take credit risk , but the cost to buy credit default insurance on investment grade bonds (measured by credit default swap indices) closed the week well below levels during the Covid pandemic. The investment grade index also closed below the level in late in 2022 and early 2023 when rising inflation and supply chain issues were in the headlines.

• Commercial paper yields actually contracted a bit last week when measured against Treasury benchmarks, with the three-month yield declining seven basis points (vs. a four basis point decline for the three-month Treasury bill). Money market investors continued to buy without demanding an increased risk premium.

• Liquidity diminished modestly but did not collapse as it did in the spring of 2021. Bid/ask spreads in the Treasury bill market were one or two basis points wider over the week. This was double the spread at the end of March. When applied to 12-month Treasury bills this meant that the cost of selling had risen from about $100 per million to $300 per million.

• Financial conditions, as measured by the Bloomberg Financial Conditions Index, deteriorated only modestly and were at about the level last seen in the spring of 2022 in the lead-up to the Fed’s first move to tighten monetary policy.

Bloomberg Financial Conditions Index
Current through April 4, 2025

Which is not to diminish the significance of the move in stock prices. Public market equity market lost around $6 trillion, and the private equity market probably lost another $1-2 trillion—we really don’t know because values are not calculated on a current basis.

The sudden destruction of this much wealth is likely to alter the growth trajectory for the economy and the path of monetary policy. The new tariffs could spur inflation, even if only temporarily, thus compounding the job of Federal Reserve to manage the nation’s monetary policy. Meanwhile the uncertain outlook for Federal spending is likely to increase demands on state and local government budgets and could lead to a drawdown of reserves and related investment balances.

In short, the sudden conflagration of the equity markets could be followed by a long burn in the short-term fixed income markets.

Deep Dive

Let’s start with the path for monetary policy and short-term rates. Fed chair Jerome Powell Friday said that the tariffs will add uncertainty to the Fed’s evolving monetary policy. Investors boosted bets on an accelerated program to reduce rates, betting (via the derivatives market) that the policy rate would be around 3.50% by year-end, down from a forecast of 4% a week earlier.

In reality it seems as if this 3.50% “average” could represent two very different paths. On one, the economy could slow with gross domestic product expanding around 1.5% (vs. 2.8 percent last year), unemployment sticking at about its current level of 4.2% and inflation persisting at 2.75% to 3%. In this scenario the Fed is unlikely to cut rates this year so the level of 4.25% will persist. On the second path recession could result in the economy contracting in real terms and unemployment rising above 5%. In this case the Fed could cut rates aggressively to a level of 2% or lower by year-end, even if inflation is sticky.

You could apply probabilities to these two very different rate paths so they “average” to a 3.5% federal funds rate, but they have very different implications for portfolio strategy, and portfolio managers would be well served to test their investment strategies against both. (Recall the story of two donkeys crossing a river where the water depth averaged five feet. One carried bags of salt, the other, bags of rocks, both of equal weight. The story goes that only one made it to the other side.)

On either path, but especially on the second, the outlook for credit is that it is likely to weaken, with a result that spreads will widen and credit downgrades will grow. Portfolio managers that utilize credit should be vigilant about credit and should also think carefully about how to prepare their constituents for this possibility. Corporate defaults could rise, and there is reason to doubt the will of Washington to come to the rescue of a troubled company. Defaults may be avoided but news headlines could be troubling, especially to the public and elected officials.

Could a tariff war lead to a loss of faith in the UI.S. dollar? Could it lead to foreign investors withdrawing from the Treasury market? These are far-fetched outcomes but unfortunately they seem a bit closer today than a week ago.

While we’re on this topic, we should note the March 25 report by Moody’s Investors Service on the credit of the U.S. government warning that government policy decisions in the near term could further diminish the AAA sovereign credit rating. (Moodys has had the credit rating of the United States on negative outlook since November 2023.) Investment policies or bond indentures that require investments in U.S. government obligations or obligations of Federal agencies to be rated AAA could become a problem were Moody’s to reduce the sovereign credit rating, since it is the last of the three major rating agencies to rate the credit AAA.

Slowing economic growth could slow or stop the growth of state and local revenue and increase demands for social safety net spending. The uncertain path of fiscal policies affecting everything from education to health services to transportation and infrastructure grants could also increase pressure on states and municipal government budgets with resulting drawdown of reserves and investment assets. We’ve cautioned about this possibility several times in recent posts. The events of last week increase the likelihood that after several years of growth, boosted by solid state and local government revenue increases and a surge in interest income resulting from high investment rates, portfolio balances could be drawn down to fund spending.

It might be tempting to go for yield but liquidity and flexibility will be more valuable in coming months than in recent years.