A Note from the AB Fixed Income Trading Desk

Rates kept climbing in September, and the Fed made the policy pivot official with its first hike since 2023. The economy has held up better than most expected at the start of the year, inflation hasn’t made it back to target, and markets are increasingly questioning whether policy was ever as restrictive as assumed. With further hikes already largely priced in, we think the bigger challenge for investors is adjusting to an economy that may be able to run with a structurally higher neutral rate. That backdrop calls for flexible portfolios and active management, and it makes the income and diversification on offer in fixed income more valuable than they have been in years.
 

Market Recap: What Has Happened in Markets Recently?
 

September extended August’s story of rates moving higher globally, but with broader repositioning as 10- and 30-year Treasury yields broke through technical support and gapped above the range they’ve traded in since the global financial crisis (GFC). The 10-year rose 54 basis points (bps) on the month to 5.29%, and the 30-year closed at 5.64%, well above the post-GFC high of 5.31% it set in August. In the US, the Federal Reserve made its shift from easing to tightening official, raising rates 25 bps to 3.75%–4.00%, its first hike since July 2023, with a decidedly hawkish message that more could follow.
 

The swing in expectations has been dramatic. At the start of March, markets priced the fed funds rate to end 2027 near 3%; today they price 4.67%, a meaningful swing of six 25 bps hikes and cuts (Display 1). Despite the focus on the long end, the repricing has been sharpest at the front. The two-year is up 141 bps this year versus 111 bps for the 10-year, and the 2s/10s curve briefly flattened to 20 bps in late September, its flattest since early 2025 (Display 2).
 

The drivers for the reversal have been gradual but came to a head in late summer. Earlier this year, the consensus expected restrictive policy to cool growth and hiring enough to bring inflation down and let the Fed keep cutting. While hiring has slowed, the broader economy hasn’t and the unemployment rate has actually improved. GDP grew 2.2% in the second quarter, profits have strengthened, and unemployment (4.2%) and jobless claims (near 200,000) remain low, eroding the case for need for the Fed to cut. At the same time, progress on disinflation has stalled. Inflation never returned to the Fed’s 2% target and has proven stickier at current levels, with core personal consumption expenditures (PCE) still running at 3.0% (Display 3), complicated first by tariffs and now by an energy shock that has pushed headline CPI to 3.4%. Higher crude oil prices have captured headlines, with the WTI ending September at $96 versus $57 at the start of the year, but diesel and refined products are also severely elevated and matter more to the real economy, flowing through trucking, agriculture and industry into producer prices, food and margins. They can climb sharply even when crude is stable, as seen in retail diesel hitting a record $6.53 a gallon in late September, well above its 2022 peak.
 

AI is increasingly part of the story, as well. Its theoretical productivity benefits are likely to be substantial, but its near-term effects are more tactile: data centers, electricity, chips, construction and financing. That build-out is supporting aggregate demand and competing for capital and scarce resources, so AI may prove disinflationary over the long run through productivity improvements even as it adds to inflationary pressures today.
 

Together, resilient growth and sticky inflation have pushed markets toward a more consequential conclusion: monetary policy may not have been as restrictive as believed. If a policy rate of 3.50%–3.75% wasn’t restraining the economy, the neutral rate is higher than assumed, and so is the likely destination for this cycle, even after temporary inflation shocks fade. The 10-year yield has risen 111 bps this year, and real yields, up 100 bps, account for nearly all of the move; long-term inflation expectations have barely budged, with the 10-year breakeven up just 11 bps (Display 4). The takeaway from market pricing is that investors aren’t bracing for runaway inflation, they’re instead repricing the real cost of capital.
 

Portfolio Manager Perspectives: What Does AB’s Portfolio Management Team Think?
 

With rates likely higher for longer, the key question is whether the economy can absorb a higher real cost of capital. History offers some reassurance: a modest removal of accommodation has rarely triggered a major sell-off in equities or credit, and the most difficult periods for investors have come with far more aggressive tightening. We’re focused less on whether the Fed hikes again and more on how quickly rates rise, how high they go and how long they stay restrictive, each of which depends largely on inflation and the labor market.
 

On inflation, the issue is whether the energy shock stays a relative-price shock or broadens. So far it largely hasn’t broadened: core CPI is up 2.4% over the past year, and core PCE has risen at roughly a 2% annualized pace over the past three months. Higher diesel, freight and food costs become a policy problem only if they migrate into services, wages and inflation expectations, and higher rates can cool demand but can’t ease supply-side constraints. They can’t produce more oil, electricity, shipping capacity or data centers. Labor isn’t generating the wage pressure that would make the shock more durable. Aggregate paychecks are growing at a modest pace, with average hourly earnings up 3.0% over the past year, consistent with stability rather than overheating as seen post-pandemic. If inflation stays sticky while wage growth and inflation expectations remain contained, the case for a prolonged tightening cycle is less compelling.
 

We also expect that labor is where the economy is most vulnerable. The market remains in a “low hire, low fire” environment. Payrolls rose just 29,000 in September, July was revised to a loss of 10,000 and job growth has averaged only 45,000 a month over the past year, yet the layoff rate is still near 1%. And with fewer foreign-born workers and a lower participation rate, the breakeven number of jobs needed to sustain the employment rate is lower. That equilibrium can persist, but it is fragile: if layoffs rise while hiring stays subdued, there are few openings to absorb displaced workers, making the Fed’s trade-off far harder. Hiring must improve before layoffs rise, so claims, JOLTS hires, temp employment, hours and unemployment duration are more informative than the headline payrolls numbers. It is also the real test of the AI thesis. AI can succeed enormously for individual companies without an equally powerful benefit to households. The broader payoff arrives only if productivity and profits translate into hiring, wages and real incomes, and ultimately into the consumption that drives the US economy.
 

In markets, the indicator we’re watching most closely is the 10-year real yield, our best gauge of the long-term cost of capital. At 2.93%, it has moved well above the upper end of its post-2022 range, which peaked at 2.52%. Higher real yields raise hurdle rates and discount rates and compress valuations, but more important is whether tighter financial conditions begin to weigh on investment, hiring and consumption. For this, we are watching earnings: rising real yields alongside resilient earnings suggest higher rates are primarily a valuation challenge, while rising real yields alongside falling earnings expectations would signal that tighter conditions are reaching the real economy.
 

In fixed-income markets, we would expect credit spreads to capture expectations that higher rates are stressing borrowers. In IG, we see no sign of it yet: IG spreads are only 5 bps wider on the year, even as yields have climbed from 4.8% to 6.0% (Display 5). HY is starting to widen at the margin, with spreads roughly 50 bps wider in September to 312 bps, though still tight by historical standards and the distressed cohort of credits skewing the index level. With HY yields now above 8%, investors have a more attractive entry point than they had just a few months ago, and historically yields, not spreads, have been the stronger predictor of forward returns.
 

Investment Implications: How Should Investors Position Fixed-Income Portfolios?

While we don’t think abandoning equities, betting on an AI bust or retreating to cash is prudent, there are a multitude of reasons to be wary of portfolios that only work if the economy follows one particular path. If inflation cools before the labor market weakens, hiring picks up before layoffs and AI spending starts to show up in productivity and household income, the economy can keep growing at today’s levels or greater, provided earnings hold up under a higher real cost of capital. However, with yields at attractive levels today, bonds are paying for their place in portfolios with their ability to generate meaningful levels of income above inflation and for their diversification benefits. Investors should build portfolios that can participate if the economy stays resilient but that don’t depend on it.
 

Fixed income is a natural foundation for that kind of flexibility, particularly with yields across the curve and across sectors higher than they have been for much of the past two decades. Here’s where we see opportunity:

 

• Global Bond Exposure Hedged to USD: A global eye is attractive because economies are at different points in their inflation and policy cycles, government-bond curves offer different combinations of real yield and duration, and issuance pressures are not uniform across markets. Hedging currency exposure back to the US dollar allows the portfolio to focus more directly on those bond market differences rather than making foreign exchange direction the dominant source of risk. A dynamic global allocation can, therefore, move toward markets where policy has more room to ease, real yields are better compensated or curves offer more attractive roll-down, while reducing exposure where fiscal or supply risks are not adequately priced.
  
  
• Globally Diversified High Yield: Credit fundamentals remain generally supportive, but opportunities are becoming increasingly dispersed across regions and sectors. A global approach broadens the investable universe while reducing dependence on any single economy or credit cycle. Active global credit selection allows us to allocate across US, European and emerging-market opportunities, emphasizing the most attractive risk-adjusted income while avoiding sectors where valuations no longer adequately compensate investors.
  
  
• Higher-Quality, Shorter-Duration High Yield: With government yields elevated and credit spreads near historical averages, we believe investors can continue earning attractive income while limiting exposure to the two largest sources of high-yield volatility: lower-quality issuers and longer-duration bonds. Active security selection within this allocation seeks to maximize income while managing downside risk through disciplined issuer selection, fundamental credit research and thoughtful duration management.
   

Bottom Line: September’s hike matters less as a single move than for what it signals: markets no longer take for granted that policy is restrictive. We can’t be certain how far this cycle will run, and investors don’t need to predict it perfectly to do well. Today’s yields pay investors to be patient, and a mix of active duration and active credit leaves portfolios positioned to benefit regardless of the path of the macro environment.

Wishing you success in your continued investment journey,
 

The AllianceBernstein Fixed Income Team

To learn more about AB’s fixed-income solutions and access other market insights, visit Fixed-Income Investments | AB. 
 

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