A delicate balance: Buoyant markets and the Fed tightrope

“...our tools can’t do two things at once.”
- Federal Reserve (Fed) Chair Jerome Powell on managing inflation versus unemployment risks.¹

“[Stocks] are richly priced. That’s the only way to describe it. I’m not going to use the B word, the bubble word, because that suggests that somehow the prices have nothing to do with earnings...the market is being held afloat by the earnings numbers....”
- Professor Aswath Damodaran, NYU Stern School of Business²

I’m writing this on the heels of our September Asset Allocation Committee (AAC) meeting. Our views on risk assets remain balanced.

Fundamentals are supportive: fiscal stimulus, falling interest rates, deregulation, merger and acquisition (M&A) activity, and AI-driven spending. Yet, we must also account for the fact that valuations are elevated, especially in U.S. large-cap growth.

One committee member summarized the tension between these two dynamics well: “We are cutting rates into a healthy economy with fiscal stimulus on the way, so it’s easy to envision a blow-off top. But valuations are high, speculation abounds, and inflation is not fully behind us.”

In short, our positioning remains:

• Neutral stance on risk assets
• Short duration
• Long diversification

Discussion on interest rates

Historically, rate cuts work to pull the entire yield curve lower, even when it steepens. We’ve had 12 cutting cycles since the 1950s. Bonds outperformed cash in all 12 instances (Fig. 1):

But this time, long-end yields may not fall. Here are some arguments in favor of this view:

• Fiscal deficits are near all-time highs. One member described this as “fiscal indiscipline.”
• Treasury supply is expanding. Heavy issuance puts pressure on long-term yields, and a borrowing binge to finance fiscal stimulus will likely shift from Treasury bills to bonds.³
• Inflation is re-accelerating. Over the past three months, price growth has been trending up, not down.
• Gold is rising as an alternative to U.S. Treasuries. Foreign central banks, which doubled their pace of bullion purchases in recent years, are still buying.⁴ Asset allocators are also treating gold as a competitor to U.S. bonds. Digital assets may be playing a similar role.
• The term premium is climbing. Investors demand more compensation for holding long-dated bonds in a world of greater policy and inflation uncertainty.
• Fed independence is scrutinized. Political pressures could undermine confidence and push long-term yields higher.

Importantly, these dynamics are not just theoretical. They are visible in recent market behavior.

Figure 2 shows the 10-year U.S. Treasury note yield (blue line) compared with the federal funds rate (green line). When the Fed cut its policy rate by 100 basis points last year, the 10-year yield rose by more than 100 basis points.

In the days immediately following the latest rate cut (admittedly a microscopic sample), we have again seen the 10-year yield move higher in response.⁵

Not much about fiscal and other government policies has been “business as usual” since COVID. We can probably say the same about capital markets.

There are important counterarguments to a long-end sell-off. Revised nonfarm payrolls have been weak, hinting at labor market softness. Some AAC members suggested that yield curve control could cap long-end yields if volatility spikes. But the majority view leaned toward positioning for higher long rates.

Unordinary yield moves

(Fig. 2) Federal funds rate vs. the 10-year U.S. Treasury note yield

Data as of September 29, 2023, to September 18, 2025.
Note: Arrows signify upward moves in the 10-year U.S. Treasury yield following the Fed’s 2024 rate cuts and September 2025 rate cut.
Sources: Macrobond and Federal Reserve.

A delicate balance

Is the U.S. labor market dangerously weak, or are headlines overplaying the significance of downward jobs revisions?

Yes, hiring is sluggish. However, new jobless claims are back to very low levels following some distorted readings,⁶ and real wage gains remain strong.⁷ These crosscurrents suggest that employment conditions aren’t sounding a clear alarm.

There’s a delicate balance to Fed policy: Hiring is likely weak enough to keep the Fed in easing mode, but inflation is edging higher, keeping policymakers on guard.

Tactical opportunities outside the U.S.

While we believe in the long-run investment case for U.S. stocks, tactically we continue to find attractive opportunities outside the U.S., led by international value as well as small- and mid-cap stocks.

A brief word on the dollar

Overall, U.S. policy remains dollar negative. “Rate cuts into elevated inflation with still-loose conditions should serve as a backdrop for a protracted weakness in the U.S. dollar,” commented one AAC member.

Consequently, we see opportunities in local currency emerging market debt. Stable commodity prices are providing further support.

Takeaways

We’re navigating a market where fundamentals support risk, but valuations and policy uncertainty demand caution. Our portfolio positioning reflects that mix: remaining neutral on risk assets; tilting away from the U.S. dollar; and embracing diversification, including opportunities outside the U.S. On interest rates, the historical pattern of falling long yields during Fed cutting cycles may not hold over the next few months. Fiscal deficits, inflation risks, and alternative stores of value such as gold are creating new dynamics. The range of outcomes has widened.