Fixed Income Outlook 4Q 2025
The Evolving Balance of Risks
The third quarter of 2025 saw a marked shift in the balance of pitfalls and opportunities fixed income investors face. Concerns rose over the state of the US labor sector, with data prints and backward revisions revealing a much weaker employment picture than expected. Markets also grew cautious on what the erosion of credibility of US institutions could mean for policymaking, while longer-dated rates have risen in markets such as the UK, France and Japan on both political and fiscal uncertainty. Simultaneously however, we have seen AI-driven capital expenditure (capex) continue at breakneck speed, boosting growth expectations, while the ongoing soft-US dollar environment has provided support for many local-currency asset classes, particularly in emerging markets. The Fed’s recent restarting of its easing cycle, assuming a recession is off the table, could also indicate good news ahead for markets. Yet with this delicate and potentially fragile new balance of risks, is it reasonable to expect markets to continue as is, or does the setup mean something could break?
Maximizing risk-adjusted returns in such febrile environments requires an active approach, in our view, that can express convictions concretely across curves and markets, but react with speed and conviction to events when necessary. For example, we remain neutral to the US Treasury curve. However, risks skew to further easing should the labor market worsen, in our view, and we stand ready to buy back in should our conviction grow. Curve positioning is also key to capturing additional value, and we continue to hold steepening biases to the US and eurozone considering long-term structural trends. Elsewhere, we continue to see opportunities in emerging markets, which could benefit further from more Fed cuts down the line. Spread sectors continue trading at historically tight levels, however we see pockets of value in some areas, including high yield and securitized credit, which offer attractive carry. We look to dynamically manage our credit exposure in this tight-spread environment, pairing them with select duration exposures to high-quality government bond markets to try and mitigate downside risk.
Heading toward the new year, we are mindful of several factors that could shape our views. US labor market weakness has become the major focus for the Fed, and further deterioration in the employment rate and jobs numbers could accelerate the easing cycle. The health of the US consumer is also up for debate with tariff cost passthrough expected to continue, potentially raising questions over US growth. Promised German fiscal expansion, meanwhile, faces execution risks, while the trajectory of AI capex spending and its sustainability is also top of mind. We prefer a flexible stance to managing our portfolios when navigating our systematic and discretionary investment views through these headwinds, giving us the chance to generate additional risk-adjusted returns for clients and the ability to adjust quickly when necessary.
Macro at a Glance
US growth soon is likely to be soft rather than recessionary, in our view. We expect already-weak consumer spending to remain suppressed for the rest of the year given slower income growth, while the housing market is also likely to remain subdued with interest rates remaining relatively high. However, business and investment activity remains strong, and we believe this can continue as peak uncertainty over the effect of tariffs recedes.
The ongoing theme of strong AI capex investment is also a likely tailwind, supported by accommodative financing conditions. The fresh weakness seen in the US labor market over the past three months however is a notable downside risk. After showing signs of cooling earlier in the year, jobs growth has slowed, with a persistent pattern of downward revisions also emphasizing the trend. This is exacerbated by the labor market’s low demand, low supply equilibrium, with new entrants finding it harder to obtain employment. How this fragile balance develops over the coming months will be key to informing growth forecasts.
The inflation picture remains dynamic, despite attention having shifted to the health of the US labor market. Tariff passthrough in the US has been slower and weaker than expected, and disinflation is also helping to offset price pressures. The passthrough is likely just delayed rather than cancelled, however, and we can anticipate prices building up in the coming months. Anchored inflation expectations and the loosening labor market mitigate the risk of second-round inflation effects.
Outside of the US, we believe eurozone inflation will undershoot target significantly in 2026, aided by ongoing euro strength and falling commodity costs, before rising back to the 2.0% target in 2027. Deflationary pressures continue to also persist in China given ongoing overcapacity issues and muted domestic spending. UK inflation is proving sticky, by contrast, with headline inflation still at double the target. A contractionary budget, however, in November could bring in disinflationary pressures. Elsewhere, Japan inflation still remains above target, buoyed by loose financing conditions and solid domestic activity.
Policy Picture: Different Stages of the Cycle
We believe the Fed will cut rates by 25 basis points in both October and December following them up with two more cuts in 2026. The Fed has delivered on its prior indications of not tolerating labor market weakness, and the material fall in nonfarm payrolls and downward revisions of previous numbers we believe puts it on the path for further easing.
Outside the US, many central banks have reined back on easing following the tariff shock, and instead are focusing on the balance between inflation and growth as we look toward the new year. We anticipate both the European Central Bank (ECB) and Bank of England (BoE) to hold rates steady for the remainder of 2025 but believe that risks skew towards both cutting early next year if inflation undershoots expectations. A contractionary Autumn Budget could even convince the BoE to cut in December.
Elsewhere in the G10, we believe New Zealand still has room to cut given ongoing poor data, while soft growth in Canada informs our view that the Bank of Canada will cut by 25bps at its October meeting, with risks skewed to more easing ahead. By contrast domestic pressures continue to build in Japan regarding high inflation and robust growth, which we think should give the Bank of Japan (BoJ) license to hike in the fourth quarter. We expect easing to continue across several EM economies, helped by continued subdued US dollar and oil prices reducing inflation risks.
What We’re Watching
Fiscal Risks in Both Directions
Rising political uncertainty has exacerbated worries about government spending over the past quarter. This includes leadership changes in France and Japan, which have cast doubt on their governments’ paths forward in terms of fiscal consolidation, and broader uncertainty over economies such as the UK having weak growth, sticky inflation and rising deficits. However, we also think that the much-heralded German fiscal expansion announced earlier this year could disappoint to the downside, potentially weighing on eurozone growth. The new budget was only approved in September, and the execution risks around it in both timing and delivery could result in disappointment. Looking ahead, we will be closely watching the French and Japanese political developments, the UK Budget in November, as well as monitoring progress on spending in Germany.
A Fragile Balance in the US Labor Market
The marked deterioration in payroll and employment figures, including sizeable downward revisions of nonfarm payrolls data, led to a sharp re-evaluation of the overall strength of the US economy during the quarter. The Fed’s return to easing is framed as “risk management” against this slowdown, with two further cuts penciled in before the end of the year. However, the makeup of the labor market is notably fragile, with fewer people leaving work and fewer people able to find jobs. This “low hiring, low firing” dynamic could be much more sensitive to economic shocks. How the labor market plays out in the near term will likely dictate the course of Fed easing.
The Consumer in the Face of Tariff Passthrough
The AI capex cycle, tariff frontloading and the weaker US dollar helped drive the resilience seen over the past quarter. However, we recognize that some of these factors may not last and are paying particular attention to the health of the US consumer. Companies may start to pass costs through to customers as tariffs become normalized, however the extent to which they can do this is questionable given the considerable weakness shown by the labor market. Similarly, although the AI capex boom has shown significant momentum and acceleration, it remains to be seen whether this will be sustained if the economic backdrop remains febrile. Our view is that the US consumer appears to be bending rather than breaking, and that the status quo can continue with the Fed in risk-management mode. However, we remain cognizant of the downside risks to this view, particularly if the labor market continues to trend downwards.
Asset Class Outlook & Potential Opportunities
Interest Rates
The Fed is currently in risk management mode, in our view, putting emphasis on trying to stabilize signs of labor market weakness. The September dot plot indicated that the Fed’s base case was also for two more cuts this year, but with a narrow 10-9 split among the committee. We believe this baseline is firmer than the split suggests however, assuming Powell and other core Federal Open Market Committee (FOMC) members were among those backing two cuts. In Europe, we expect the ECB to remain on hold for the foreseeable future.
Opportunity: Continued policymaker divergence provides investors with the opportunity to express views in different sovereigns across the curve and diversify their duration exposures.
Currencies
While we have entered a Fed easing cycle, there is reason to believe that this will not be structurally bearish for the US dollar. Sticky inflation and bullish US equity markets can provide support and offset falling currency yields the Fed’s dovish reaction function. Historically, the dollar also tends to rally or remain level after an initial Fed cut that isn’t followed by a recession, and we do not expect a significant downturn ahead. Upcoming labor market data and inflation releases remain critical to the dollar’s path looking forward.
Opportunity: Tariff-related inflationary effects and AI-driven equity market performance are positive factors for the dollar; however these are counterbalanced by the Fed easing policy. Overall though we still feel the dollar can rally in risk-off environments, particularly ex-US.
For more information on our asset class views and opportunities for investment grade, high yield credit and banks loans, agency MBS, securitized credit, emerging market debt, municipal bonds, responsible investing, and liquidity solutions download our Fixed Income Outlook.
