Fixed Income Outlook 3Q 2025
Decoding Dispersion and Divergence
The first half of 2025 was marked by significant market volatility and rapid shifts in sentiment due to a series of catalysts, including US tariffs, rising long-end government bond yields, and geopolitical uncertainties. Despite initial sell-offs driven by heightened uncertainty and fears of economic deterioration, the outlook improved, leading to a recovery in financial asset performance. This recovery was supported by tariff de-escalation, a resilient US economy, a Fed willing to respond to labor market weakness, stabilization of long-end bond market volatility, and the avoidance of worst-case geopolitical scenarios. Enthusiasm for AI-related capital expenditure has also buoyed broader risk sentiment. In the second half of 2025, the focus shifts towards discerning the tangible consequences of tariffs on inflation, employment, company earnings, and consumer spending. In addition, while fiscal and geopolitical risks have receded for the moment, they remain potential sources of future market volatility.
In our clients' fixed income portfolios, we stay focused on generating income and delivering total return. We have increased our relative value interest rate exposures to capitalize on divergent central bank actions, as the tariff shock generally reinforces disinflation and dovish policies outside the US. We are also positioned for yield curves to steepen in several markets, including Europe and the US. Additionally, we see opportunities in emerging market (EM) local rates, benefiting from high real rates, dollar weakness, stabilized energy prices, continued disinflation, and monetary easing, particularly in Asia and Central and Eastern Europe (CEE). We supplement our discretionary exposures with systematic strategies to capitalize on short-term market dislocations. Despite sound credit fundamentals, historically tight spreads and potential cyclical weakness, lead us to maintain moderate overall exposure to fixed income spread sectors, with a preference for securitized and high yield credit
The dollar remains a notable exception to the year-to-date rebound seen in most other assets and is a subject of much debate. We anticipate a more nuanced path forward. Regional asset allocation diversification and rising hedge ratios on US asset holdings by global investors may exert downward pressure on the dollar. However, we expect the dollar to retain its status as a safe-haven asset during risk-off events, especially those originating outside the US, and its position as the world's reserve currency. Consequently, we hold an underweight stance on the dollar but use currency options to position for potential episodes of upside. Overall, our approach is deliberate in assessing risks, disciplined in capturing income and relative value, and dynamic in leveraging systematic strategies and active management to modulate our exposures.
Top of Mind
The convergence of higher interest rates, budget deficits, elevated debt levels, slowing nominal growth, and demographic aging pose headwinds to long-term fiscal sustainability globally.
Dollar depreciation may extend due to regional asset allocation diversification, a potential increase in hedge ratios on US asset holdings by global investors and narrowing growth and rate differentials but we don’t expect the downtrend to be linear.
Germany's announced fiscal push has pulled forward optimism in European assets, but execution challenges could alter the path ahead.
Macro at a Glance
Growth: Steady Deceleration
US economic growth data from early 2025 has been distorted by anticipatory behavior related to expected tariffs. Importers front-loaded imports and built-up inventories to avoid tariffs, which artificially depressed 1Q GDP growth figures. A corresponding reversal of these effects is expected to boost 2Q data. While the US One Big Beautiful Bill Act (OBBBA) may appear substantial, its impact on growth is projected to be limited. This is because the bill primarily prevents fiscal policy tightening by extending the 2017 tax cuts. In addition, the structure of the OBBBA's tax cuts favors higher-income individuals, who are likely to save a portion of any additional income, especially if they perceive the tax changes as temporary. In contrast, the bill's proposed cuts to social safety net programs like SNAP (Supplemental Nutrition Assistance Program) and Medicaid could significantly affect spending by lower-income consumers.
Concurrently, the US labor market, a key determinant of consumer spending, is gradually slowing. Evidence includes downward revisions to payroll data, narrower job gains, slower private sector growth, elevated jobless claims, and declining consumer confidence in the job market. The decrease in the unemployment rate to 4.1% in June was mainly due to a reduction in labor force participation rate, rather than robust job creation. This decline in participation could be a sign that tighter immigration controls are beginning to take effect. The revocation of work visas for certain immigrant workers may reinforce this trend in the coming months. Overall, we expect slower US economic activity due to the impact of tariffs, which will only be partially offset by fiscal policies. However, we anticipate slower growth, not an outright economic contraction
Europe is currently exhibiting positive economic momentum and China has experienced a temporary boost to its economy due to accelerated exports ahead of the anticipated tariffs. However, both the European and Chinese economies remain susceptible to adverse effects from the implemented tariffs and any significant deceleration in US economic growth. Despite tariff headwinds, fundamental strengths within the global economy, such as healthy private sector balance sheets in many major economies, suggest that global economic expansion is likely to persist, although at a more moderate pace than previously observed.
Inflation: Country Divergence
Recent US inflation data shows disinflation in the services sector, including rents, and only a limited initial pass-through of tariff costs to consumer goods prices. We expect the impact of tariffs on inflation to become more evident in the coming months. However, the fluctuating nature of tariff rates may delay price adjustments as businesses await greater clarity, and the large stock of inventory built up in advance of tariffs could also contribute to this delay. That said, we believe the inflationary impact of tariffs in the US will be less severe and shorter-lived compared to the inflation surge in 2021-2022. Several factors support this view:
- We anticipate a peak inflation rate of 3-4%, much lower than the 9% peak during the pandemic. This reflects a narrower breadth of inflation, contained supply chain stress, and continued services disinflation.
- The labor market is not as tight as it was during the previous inflationary period, reducing wage pressures.
- Unlike 2021-2022, household spending power is not being boosted by government stimulus checks.
- 1Q earnings season commentary suggests that companies are mitigating tariff-driven input cost increases through supply chain diversification, cost reductions, and inventory stockpiling, rather than solely passing on costs to consumers (though some pass-through is still anticipated).
- Long-term inflation expectations remain well-anchored
We would become more concerned about persistent tariff-driven inflation if country-specific tariffs rose back to prohibitive rates or if tariff revenue is used to provide broad-based stimulus checks for consumers. Outside the US, we generally expect tariffs to reinforce disinflationary trends. The Euro area has achieved its 2% inflation target, while the UK is experiencing disinflationary pressure due to a slowing labor market and reduced economic activity. In China, manufacturing overcapacity, weak domestic demand, and demographic challenges are expected to continue to contribute to deflationary pressures. Conversely, an upswing in domestic demand and wage growth are expected to sustain inflationary pressures in Japan.
Policy Picture
Steady Easing
Although the Fed has maintained a steady policy stance this year, recent communications indicate low tolerance for labor market weakness. We anticipate two rate cuts in 2025, one in September and another in December, contingent on steadily rising unemployment and a temporary inflation boost from tariffs. Outside the US, the tariff shock supports easing paths across smaller DM and EM economies, although easing actions may slow as policy rates approach neutral. We expect the BoE to resume rate cuts in August, followed by consecutive reductions starting in 4Q, ultimately lowering the Bank Rate to 3.25%. This forecast is based on expectations of slower growth and continued labor market loosening. We also foresee further easing in Europe, though German fiscal plans, which imply a more front-loaded growth uplift than previously anticipated, may slow the ECB down. Meanwhile, we believe global financial stability and domestic price pressures will pave the way for the BoJ to resume rate hikes. Additionally, we expect further easing among smaller DM central banks, such as those in Sweden and Canada. Easing actions are also expected to continue in EM economies, particularly across Asia and Central Eastern Europe, with the recent pullback in oil prices and dollar weakness alleviating inflation risks.
What We’re Watching
Tariffs and Trade
The coming months will be pivotal in assessing the true economic impact of the implemented tariffs. Drawing from the 2018 trade war experience, we expect a 3–4-month delay before tariffs significantly influences consumer prices, suggesting the impact will become more noticeable this summer. However, this timeline could be extended due to the current volatility in tariff rates. It will also be crucial to monitor the job market's health and its capacity to sustain consumer spending, as the tax-like effects of tariffs begin to weigh on disposable incomes. Additionally, we are closely watching the progress of ongoing trade negotiations, with sector-specific tariffs on pharmaceuticals, semiconductors, and critical minerals remaining a possibility.
Corporate Earnings
Corporate bond investors have found reassurance in the continued resilience of credit fundamentals, as reflected in 1Q earnings season. Recent company guidance in the US points towards slower hiring (influenced by both tariffs and the rise of AI), constrained capital expenditure beyond AI-related investments, below-potential economic growth (though not a recession), and a one-time inflationary effect. As we move into 2Q earnings season, a central question is whether the strong earnings performance earlier this year was driven by pulled-forward activity or genuine, sustainable resilience. Our research analysts will be closely assessing how tariffs are impacting corporate profit margins: Are companies successfully passing increased costs onto consumers, or are profit margins being negatively affected? We will also focus intently on forward guidance, particularly regarding hiring plans and capital expenditure forecasts.
Geopolitical Risks
The recent escalation in geopolitical tensions in the Middle East serves as a stark reminder that fresh shocks can emerge unexpectedly. However, unless the worst-case scenarios materialize, the impact on financial markets tends to be short-lived. While recent geopolitical tensions have subsided, a more transactional approach to security alliances and global trade suggests that flare-ups may become more frequent. The most critical factor for investors to monitor is the potential economic impact on energy supply and prices. However, it is equally important to assess which economies are more reliant on or resilient to energy price volatility
Our full 3Q 2025 Outlook explores our Top of Mind themes in detail, and examines potential investment opportunities across interest rates, currencies, investment grade credit, high yield credit and bank loans, securitized credit, agency MBS, and municipal bands.
