What’s going on with Treasury rates?

The April 2 “Liberation Day” tariff announcement sent stock markets reeling, as economic uncertainty intensified and recession risks rose. Invesco Fixed Income’s own assessment of the probability of recession increased after the announcement. But Treasury yields rose as well, especially longer-term yields. Normally, we would expect Treasury yields to decline in the face of uncertainty and equity volatility. The April 9 tariff pause provided some market relief, but longer-term Treasury yields are still higher than they were before the Liberation Day announcement. Why are rates behaving this way, and what does this mean for investment grade bond investors? We answer the most common questions we’re hearing from clients now.

What caused long-term Treasury yields to rise after the tariff announcements?

Three main factors appear to be at play in the recent rate moves: market technicals, market fears and international sentiment. One of the drivers was likely the unwinding of a popular trade that sought to take advantage of the gap between Treasury yields and Treasury swap rates.¹ Investors in this trade expected future banking sector deregulation to allow banks to demand more Treasuries, which would potentially increase Treasury prices and narrow the gap between Treasury yields and swap rates.

However, as market volatility picked up after Liberation Day, investors sought to reduce leverage in general. As investors closed out these leveraged trades, they sold Treasuries and received swaps, which drove Treasury prices lower. We believe this “unwinding” trade was partly responsible for the move in Treasury yields in the week following April 2. Our sense is that much of this unwind is over.

Market fears also likely played a role in driving Treasury rates higher — fears around foreign appetite for US Treasuries and a potential increase in the supply of Treasuries. While in the past, foreign investors have provided a large chunk of the funding for Treasuries, if the US decouples from the global financial system, domestic investors would likely be required to step in, and they may demand a higher return. Also, if the US tips into recession, government bond issuance may have to increase, putting pressure on yields.

What’s the Federal Reserve’s next move?

While we don’t think we’re out of the woods, the tariff pause reduces the odds of a recession. The outlook for the Fed is unclear, but so far, it has held the line on keeping policy steady. We think the Fed has time to assess the impact of tariffs — and we think it will take it. The March labor market numbers were strong, for example. We think the Fed will wait to cut rates until it sees signs in the data that tariffs are impacting the real economy. It doesn’t seem inclined to step in to ensure the stability of financial markets, which have remained largely orderly so far. It could end quantitative tightening or signal other measures if needed, but we don’t seem to be there yet. We believe the market’s reaction to rate cuts in this environment is also uncertain — it may not interpret cuts positively.

How have investment grade bonds performed in recent weeks?

Overall, investment grade credit has remained orderly and has performed well relative to equities and riskier fixed income.² So far this year, interest rates have been the driver of positive returns, while credit spreads have widened. Investment grade credit spreads have widened from the low 70 basis point range late last year, to as high as 118 basis points following the tariff pause.³ To put this in historical context, the investment grade spread over Treasuries has averaged 120 basis points since 2015.⁴ Notably, since that time, the average credit quality of the investment grade index has improved, duration has shortened and liquidity has improved, which is why we believe spreads should be lower than the historical average.

How do you expect investment grade to perform from here?

Looking at today’s higher yields, we believe there is more value in corporate credit now, allowing more room for harvesting alpha. But if we take the case of a recession, spreads could go wider from here. Credit spreads have typically widened to 150-200 basis points over Treasuries in recessionary environments.⁵ As a counterpoint, we would reiterate the sound fundamental positions of corporate issuers and the reasonable levels of leverage at both the corporate and consumer levels of the economy. We’ve also seen how rapidly markets can snap back on headlines. So far, the economy is still in good shape and there are no signs of recession in the hard data. The recent pause in tariffs offers the possibility to avoid the worst-case economic scenarios before the damage is crystalized.

What are the main tenets of your investment grade strategy?

Prior to the new tariff policies, we were positive on the economic prospects of the US and saw strong technical demand for investment grade US bonds. However, this dynamic was balanced by tight valuations that offered less cushion in the case of a recession or risk-off event. As a result, we had already favored lower exposure to emerging markets and credit overall. However, we still think interest rates are ultimately headed lower. The market is currently pricing three rate cuts in 2025 and the potential for a fourth cut.⁶ If there is an economic slowdown, we believe the path for intermediate rates should be lower.

More importantly, we believe an active manager is likely to navigate more effectively and efficiently in different risk environments. We expect technical factors to continue to drive market dislocations in spreads and sectors going forward. For example, in markets in which equities are underperforming, large institutions may have to sell bonds to buy more equities to maintain their bond-to-stock ratios within the band defined by their investment policies. This type of indiscriminate or panic selling can create pockets of opportunity for active managers. In the meantime, investment grade bonds have been doing the job of bonds: Providing a high level of income while acting as ballast in portfolios and still remaining liquid.