Financial Institutions Insights 3rd Quarter 2025 Q4 Strategy

TONY ALBRECHT & PATRICK LARSON 

Q4 Strategy 

The 3rd quarter was very good for many investors. Interest rates declined, the Fed lowered the fed funds rate by 25 basis points, the NASDAQ advanced 11% and the S&P 500 increased 7%. Most fixed income indices had returns for the quarter of between 1% to 3%. Labor markets are softening which gave the Fed the ability to lower rates despite inflation being above their 2% target. While tariffs remain a key part of the current administration’s strategy, the daily volatility seems to have calmed down. GDP has been higher than expected, which bodes well for growth in the 4th quarter. 

Interest rates declined last quarter as the Fed lowered short-term rates on September 17th. The 2-year maturity Treasury through the 30-year bond all declined by roughly 10 basis points. The market is pricing in two more rate cuts of 25 basis points in October and December. Job growth continues to disappoint, and the Fed has taken notice. Fears of an uptick in inflation caused by tariffs have largely not materialized, providing the Fed with justification for easier monetary policy. 

One of the most frequently used types of fixed income securities we utilize is investment grade corporate bonds. Liquidity is usually excellent, defaults are very low and the additional yield an investor receives versus a risk-free U.S. Treasury is normally quite attractive. The additional yield is called the credit spread. If the 5-year Treasury yield is 4.60% and a 5-year industrial issuer corporate trades at 5.00% the credit spread is the difference between the two or 0.40% (40 basis points). Unfortunately, this spread is the lowest is has been in well over 10 years. Investors are not getting compensated for credit risk as compared to long term average experience. Our approach is to underweight corporate bands and buy the higher rated investment grade credits for exposure to this asset class. 

Given an environment where credit risk is priced poorly from an investor’s perspective on a historical basis what other assets offer a viable option? Agency-backed mortgage-backed securities (MBS) have many attractive features. They have no credit risk, excellent liquidity and a wide variety of maturities, coupons and prices. Investors can decide if they want a 15-year maturity trading at a discount, a 20-year maturity trading at par or a 30-year maturity trading at a premium. Each option has its own unique set of risks depending on the movement in interest rates. Yields range from the 4.0% to a bit above 5.0%. 

Given there is a plethora of MBS to choose from starting with bonds selling at a discount, par or a premium, it can be confusing to pick one. It really boils down to your outlook for interest rates. If you believe rates will be falling buy one trading below $100. If your outlook is for stable rates choose the coupon trading near $100. If you think rates will be rising the MBS trading at a premium will provide the highest yield. Keep in mind mortgages can be prepaid. Any prepayments get returned to the investor at $100. If you purchase an MBS trading at $95 and get prepayments at $100, your yield will be higher than at the time of purchase. The opposite holds true if you paid a premium and rates fell, resulting in faster prepayments. If you want to minimize the impact of prepayments stick with MBS trading near $100. 

Year to date municipal returns have been coupon-like, which isn’t bad considering we are near the highest yields generally enjoyed since before the Great Financial Crisis. The liquidity premium that munis often experience makes them even more interesting relative to other sectors of the fixed income market, especially in the longer half of the yield curve. Munis out in the 30-year area can be found with yields of 4.5% for high quality issuers. For some investors, that likely results in a taxable equivalent yield that may approach junk bond corporate bond yields (consult your tax advisor for tax advice, ACG does not provide tax advice). The elevated current coupons offer a degree of cushion against the risk of rising rates, attractive taxable equivalent yields if yields go sideways, and if bond yields fall a investors should enjoy returns that exceed the coupon. The good news is that longer municipal bond yields offer historically attractive yields which should offer an above average return experience for investors at the current rates. 

The bad news for munis involves credit deterioration rather than the genuine risk of default. U.S public school districts are increasingly tapping into reserves as they face financial challenges, namely the reality that Covid funds would appropriately disappear following the conclusion of the pandemic, along with lower headcounts for schools that are not competitive or appealing to students with alternatives. As of June 2025, the number of negative rating or outlook revisions assigned to school districts increased 40% on a year-over-year basis. Nearly a third of the schools rated by S&P had operating deficits in 2024 as compared to 17% in 2021. Schools are under budget pressure, but they are an essential service, and the populace will support the great economic escalator, education. We are just about to enter our annual credit assessment of credits to which ACG clients are exposed. We have seen some deterioration of school district credits, but the ebb and flow of creditworthiness may be more likely to reduce liquidity of school bonds, rather than materially increase the risk of loss on a credit. In the end it may present an opportunity to buy quality issuers at enhanced yields as people throw the baby out with the bathwater. 

As the Fed cuts rates once or twice more in 2025, the yield curve should experience a continuation of the “bull steepener,” with short rates moving lower than the intermediate part of the yield curve and the long end of the curve will be anchored near current levels until some clarity about the federal deficit and supply of new debt become clearer. Short-term bonds continue to be a stabilizing part of our strategy. There is a lot of yield/return for the modest risk being assumed with short term bonds and cash equivalent securities. 

Historically, when bond yields are at elevated historic rates, it is a good time to “go long” in bonds. This Fed easing cycle is not your garden variety cutting cycle, and when considered alongside the possibility of a binary interest rate outlook makes longer bonds a prudent choice but also one that is very uncomfortable. There are no easy returns to be earned in the financial markets. It feels like a stock pickers equity market which may also have a healthy dose of what has worked to this point in 2025 continuing to perform, and bond managers will be nimble to navigate this treacherous market. 

Q4 Interest Rate Outlook – A Supreme Fork in the Road 

In the next month we suspect people will become much more familiar with the International Emergency Economic Powers ACT (IEEPA). On November 5, the Supreme Court will hear the case where a lower court found on a seven to four basis that the tariffs enacted by President Trump exceeded his presidential authority. There are many people that expect if the Supreme Court upholds the lower court decision, President Trump will just pursue another approach to enacting the tariffs. We would argue that it would make the most sense for the President to have started with the approach that was both expedient and had the best chance to survive court challenges. Absent a favorable Supreme Court decision, the most successful and durable approach would be through passage of a bill by a majority vote by both houses of Congress. The Trade Expansion Act allows the President to impose tariffs for national security reasons for a limited time, so it may be that the “trafficking” tariffs related to the fentanyl crisis, human trafficking, and border issues may have a stronger standing than the “base” tariff of 10% and the “reciprocal” tariffs. The trafficking tariffs are largely targeted at China, Canada, and Mexico. Given the effective tariff rates for Canada and Mexico are 25 to 35 percentage points higher than before, and since they are some of our largest trading partners, if the Supreme Court overturns the lower court ruling, even if it just applies to the trafficking tariffs, the revenue from the trafficking tariffs could raise between $145 billion to $250 billion, annually. On the high end of the estimated range of revenue, the trafficking tariffs could nearly make President Trump’s One Big Beautiful Bill nearly deficit neutral, as it has a 10-year price tag of $2.8 trillion while trafficking tariffs could raise $2.5 trillion over the same decade. However the case is decided, it appears to be the lynchpin for the success of the Trump administration’s economic policy. 

We anticipate that the Supreme Court decision has the weight to make or break the 4th quarter. Investors have driven the term premium (the yield investors demand for loaning their money out for incrementally longer periods of time) higher. It suggests they are nervous about the amount of federal debt outstanding, persistent deficit spending, political division which may make for more extreme and diametrically opposed outcomes from each of the party’s “solutions” to the problems at hand. There are numbers that support some introduction of caution. According to Bloomberg, the current interest cost for the U.S. relative to total tax revenue has climbed to approximately 17.5%, while the balance of the world pays on average less than 10% in interest cost relative to total tax receipts. The number for the U.S. is nearly 70% higher than where it was a decade ago and we haven’t had numbers this high since the early 1990’s. The U.S. is not alone on the assumption of and outsized debt burden. Many developed market economies are seeing a deterioration in liquidity. Reduced liquidity with higher interest payments can be a predecessor to the dreaded “doom loop” where a government is forced to borrow more money at ever higher yields to pay interest, which can result in a cycle which can compound the problem. Profligate spending isn’t unique to the U.S, many developed countries have seen legacy debts pile up. Contributing to the current state is the unholy matrimony of many developed market issuers having the luxury of issuing bonds in the currency they print, and the pain-free hyper-low-interest rate environment that coincided with the Covid pandemic. Unfortunately, the inevitable pain was deferred until interest rates normalized. That’s where we find ourselves today, picking up the tab and making difficult decisions related to the excess spending related to the pandemic, and the two decades that preceded that seminal episode. 

The Fed has reduced the pace of Quantitative Tightening to a pace of $5 billion per month and the natural portfolio “roll off” of the Fed’s Mortgage-Backed-Security portfolio results in its balance sheet shrinking by roughly another $17 billion per month. The effect it has is to put downward pressure on bank reserve balances. This in itself isn’t alarming as the Fed had a goal of taking bank reserves from being “abundant” to being “ample.” In that transition there will be a delicate balance of finding the right stopping point. Go too far and funding markets can misbehave, and the Fed will have to jump back in to shore up reserves or funding mechanisms and if they wait too long the chill can spread to the credit markets. A related metric to watch is the reserves-to-bank-liabilities ratio. We currently sit below 14%, a rate not seen at that low of a level since early 2020. For added context, that measure of bank reserve health made a steady decline from a number closer to 16% in the period between 2015 through 2018 and fell to 14% in 2018 and declined below 10% in 2019. As part of the Covid response, the number exceeded 20% in 2021. In 2018, when we got to the current level, it seemed to precipitate the rise in money market, and other short-term borrowing rates. Another sign of potential stress is that repurchase agreement (repo) rates are seeing an increasing yield spread as compared to the Fed funds rate. Dallas Federal Reserve President, Lorie Logan points to the significance of the repo market because it entails more than $1 trillion of trade volume per day, which sees a full order of magnitude more than the Fed funds market. Admittedly, this “funding stress” is both nuanced and possibly premature. Again, the Fed wants to take bank reserves to an “adequate” position, and in doing so there isn’t a prescribed point at which it is obvious to stop. It may be a “management by feel” exercise, but in the event they go too far, there could be a temporary point at which markets sputter and a Fed backtrack may either support or shake the confidence of the markets. 

Although the Supreme Court decision may be more nuanced than a simple binary solution, where tariffs are either allowed or disallowed, gaming the two scenarios may offer a window into what faces the market. The themes of de-dollarization, the rise in gold and Bitcoin values, and the increase in the term premium suggest the market has concerns. We have talked about projections related to the debt-to-GDP ratio of the United States. It seems like the Supreme Court decision will directly determine the path of our future. Tariffs are a broad-based tax on consumers. It is speculated that the burden of the cost falls on the shoulders of consumers, but as mentioned last quarter, business efficiencies and possibly profit erosion, both foreign and domestic may absorb some of the impact. To a degree tariffs are a shared revenue burden. If tariffs are allowed to stand, it may be an unexpected tool to get our deficit in check and move toward a path of a sustainable debt burden. It would likely temper the term structure increase, expected Treasury issuance could decrease, and the dollar should have an impetus to appreciate relative to other global currencies. Many positives come from the scenario where tariffs are upheld and the negatives for economically challenged segment of the population can be addressed as needed. If the Supreme Court decision goes against the Trump Administration (ignoring a successful workaround), projected deficits related to the One Big Beautiful Bill Act and the potential deal-making related to the government shutdown, will shock the markets. The term premium may worsen, de-dollarization should expand, anticipated issuance of Treasuries could cause higher borrowing costs and Treasury auction challenges, and the onshoring economic lift that the tariffs have encouraged would diminish. In general, we will have strained our relationships with allies with nothing to show for the expended political capital. In short, it would very likely be a very bad day for bonds. Beyond simple asset class performance, the absence of tariff revenues will likely push the resolution of our deficit spending crisis out to the point where we don’t get to make choices in an orderly fashion, at a point the funding markets will make the tough decisions for us. Artificial intelligence froth or not, it may trigger a “risk off” moment for the financial markets. The decision in November and any credible workarounds will impact the financial markets, it may seep into Fed policy, consumer sentiment, and the trajectory of the United States. 

On a near term basis the Fed may find that the neutral rate is lower than previously thought due to several factors, including a productivity lull, aging demographics and immigration trends. Although less immediate than the status of tariffs, the progression of artificial intelligence will disrupt many aspects of our economy. Productivity could go through the roof, which would suggest a dramatically higher future neutral rate for Fed policy. The potential impact may call into question the portion of the Fed’s mandate aimed at full employment. Putting on our “futurist” hat, the combination of AI and humanoid robot technology could fundamentally change the employment environment from a top down and a bottom-up perspective, respectively. The massive improvement in productivity may collide with elevated unemployment levels such that the inflationary and disinflationary influences on the economy may demand dramatic changes at the Fed. If our economy is a balance between the value of capital and the value of labor, AI seems to further the value of (immense amounts of) capital and it may diminish the value of labor. Never mind people calling for AI (AGI and ASI, to be more specific) to possibly precipitate an extinction level risk for humans, the social, tax policy, security, and governance challenges that AI will probably expose humanity to are numerous and of a magnitude that the currently divided population isn’t capable to address. It is a thought exercise worth batting around. What will be the savings rate for future college graduates with above average intelligence with limited job prospects? Will there be a glut of savings and investment (because capital may be more valuable than labor) or a lack of a savings discipline (because if you don’t have decent career prospects, you may live for today). Will an increase in the divide between the wealthy and the working class become more exaggerated? Do diametrically opposed political parties result in dramatic policy swings as we try to grapple with a technology that is beyond our comprehension? Nobody can know what the near future holds but it seems like the convenience of having an AI assistant will come at a human cost. 

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