The End of 2%? Why Investors Must Prepare for a Steeper Curve and Persistent Inflation

The Federal Reserve is discreetly endorsing a 3% inflation rate, a pivotal move that suggests a structural shift toward a sustained "higher for longer" policy and a potentially steeper yield curve. This economic turning point carries significant consequences for investor strategy, especially as the current wave of massive capital spending on Artificial Intelligence mirrors the economic conditions preceding the dot-com era.

Speaking at Schwab IMPACT 2025 last month, John Queen, Fixed Income Portfolio Manager at Capital Group, shared his analysis with ETF.com's Dave Nadig. The discussion focused on navigating this inflationary landscape, drawing unexpected historical parallels to the 1990s, and exploring how ordinary investors can gain exposure to private credit through innovative investment vehicles.

The Erosion of the 2% Target

Queen addressed the anxiety surrounding the Fed's intentions by analyzing its evolving mandate. He noted that for decades, the Fed effectively operated with a single focus: jobs. Inflation was rarely a concern, often requiring efforts to stimulate it toward the 2% goal—a history that fostered the "Fed Put," where the market expected intervention to cushion any economic decline.

"Clearly that changed in '22," Queen stated, as high inflation forced a return to balancing both mandates. While the labor market has shown signs of weakening, inflation continues to hover stubbornly above the 2% target. Queen concluded that the central bank's recent rhetoric, which appears more tolerant of current price levels while emphasizing labor stability, suggests a new policy equilibrium.

"They have tacitly accepted 3% as the new 2%," he asserted. This shift is enormous, fundamentally altering the calculus for fixed income investors.

The Case for a Steeper Curve

Nadig pointed out that a permanently higher inflation target implies that "higher for longer is actually going to be here for longer."

Queen explained the math: if the Fed accepts 3% inflation, and a long-term real rate of return on a 10-year Treasury is 1% to 2% (a reasonable risk premium), then the nominal 10-year yield should be anchored closer to 5%, not the 3% to 4% seen in the recent past.

Furthermore, he expects a divergence in rates: "You might see short rates not go up and in fact come down a bit, and the long rates up a bit higher. A little bit of a steeper curve seems like a reasonable expectation in the long run." He reminded listeners that a steep curve is not unprecedented, referencing the 300 basis point 2s30s spread observed in the early 1990s.

Tech Boom Parallels: '90s Replay?

In assessing the surprisingly tight spreads in the bond market despite volatility elsewhere, Queen drew an analogy to the tech buildout era.

"It looks a lot like the '90s in some ways to me," he said. Specifically, the mid-to-late 90s featured massive capital allocation to a new technological infrastructure (the internet) coupled with very high equity valuations. Today, the massive investment in AI by hyperscalers is performing a similar function: channeling funds into the real economy, keeping it fundamentally sound.

Nadig noted a key difference: the '99 tech boom was funded partly by a rush of corporate bond issuance, whereas the current AI spend is largely funded by existing cash balances and equity. Queen agreed, suggesting that using cash flow for investment—a scenario enabled by the huge cash flows of many tech giants—helps insulate the overall economy, similar to the period of strong fundamental growth and compressed bond volatility witnessed between 1995 and 1999.

Accessing Private Credit via Interval Funds

The conversation concluded with a focus on private credit, an asset class gaining importance as traditional bank lending shrinks due to regulatory changes.

To provide broader access to this illiquid but diversifying area, Capital Group partnered with KKR to launch a structure known as an interval fund. This vehicle was chosen specifically to manage the fundamental liquidity mismatch inherent in private assets.

"ETFs were not in our view appropriate," Queen confirmed. The interval fund structure, which permits daily investment but limits redemptions to a quarterly basis, allows the portfolio to hold up to 40% in private assets, including direct lending and asset-based finance.

This structure allows investors to benefit from the illiquidity premium without suffering the day-to-day consequences. The 60% public portion provides a crucial liquidity buffer, enabling the portfolio to invest aggressively when attractive private deals arise, or to meet quarterly redemption requests efficiently.

Queen underscored the value of this approach, especially in a low-information environment, where the credit intelligence gleaned from private market partners helps to better manage the entire portfolio, providing a valuable "new input into seeing the economy."

Disclaimer: This article is for informational purposes only and does not constitute financial advice. Market conditions can change rapidly during a shutdown. Always verify information independently and consult a licensed financial advisor before making investment decisions.