4Q2025 Market Review

The fixed income market is transitioning to a complex environment. Uncertainty about US tariffs and trade agreements has raised concerns about the inflationary impact of tariffs on US consumers and corporations. Expectations for US economic growth have declined, and the risk of stagflation still lingers. The markets are still haunted by the impact of tariffs on inflation.

Q4 2025 saw a blend of strong economic growth and rising debt, leading to increased Treasury supply, stable yields, and evolving bank reserve dynamics, all under a backdrop of persistent fiscal policy challenges.

The Federal Reserve’s dual mandate is now more focused on the weakening labor market and is acting to lower interest rates to address this issue. The weakening US dollar and the high US federal debt are concerning US and international investors of long-duration Treasury bonds.

Following a period of easing inflation and the initiation of Federal Reserve rate cuts, investors now face a landscape marked by mixed economic signals, tighter compensation for risk, and heightened sensitivity to policy, inflation, and labor market developments.

Global liquidity conditions at the start of 2026 reflect a cautious transition toward easier monetary policy, with central banks balancing disinflation progress against lingering inflation risks and slowing economic activity. While the Federal Reserve and Bank of England have begun or continued measured easing cycles, the European Central Bank remains on hold, supported by firmer growth and inflation projections. Across regions, policymakers continue to emphasize gradualism and data dependence, underscoring a fragile but improving macroeconomic backdrop.

The outlook for investment-grade corporate bonds in 2026 is shaped by a balance of opportunity and risk. Above-average yields, stable fundamentals, and strong investor demand support the asset class, but tight valuations and rising issuance require selectivity and disciplined risk management. Investors are advised to maintain a modest overweight to corporates, adopt a defensive posture, and focus on relative value across maturities and sectors to navigate the year ahead.

Venezuela

The capture of Nicolás Maduro has ended a symbolic chapter in Venezuela’s political crisis but has not addressed the country’s deep economic and institutional problems. Instead, it has ushered in a period of heightened uncertainty, marked by increased geopolitical risk, fragile market optimism, and complex transition challenges. The ultimate outcome—whether stabilization, ongoing instability, or broader regional effects—will depend on the actions of Venezuela’s security forces, the credibility of any U.S.-backed transition, and the restraint of both domestic and international actors, making the situation highly unpredictable and risky for investors and policymakers.

Fiscal Policy

Fiscal policy continues to exert some inflationary pressure, but moderating wage growth and loosening labor conditions should help contain services inflation. Labor markets are gradually weakening, with unemployment near 4.3 percent, declining job openings, and two consecutive quarters of net job losses outside the healthcare and education sectors.

Federal Reserve Policy

On January 12, 2026, the US DOJ launched a “criminal investigation of Jerome Powell’s testimony about the renovation of the Federal Reserve building,” which is expected to be unindictable.

The Federal Open Market Committee (FOMC) cut the Federal Funds target rate by 25 basis points to a range of 3.50%–3.75% to stimulate the economy. The decision, as the market expected, reflected a shift in the Fed’s focus from reducing inflation to shoring up a weakening labor market. The Fed’s outlook for 2026 predicts one more rate cut for the year. Fed Chair Powell aims to balance maximum employment with returning inflation to 2%, assessing incoming data closely.

Summary of Economic Projections (SEP)

The SEP represents the median of the individual forecasts submitted by each of the FOMC participants. The median projection for real GDP growth was upgraded to 2.3% in 2026 and 2.0% for 2027. The long-term outlook remained unchanged at 1.8%.

The median year-end unemployment forecasts for 2025 and 2026 were unchanged at 4.5% and 4.4%, respectively, and 4.2% for 2027.

Core PCE inflation, the FOMC’s preferred inflation gauge, was revised slightly lower to 3.0% for 2025, 2.5% for 2026, and was unchanged at 2.1% for 2027.

Although the U.S. government shutdown ended during 4Q2025, many of the key economic datasets that the Fed relies on to provide important information about the direction of both growth and inflation are absent. The uncertainty over data releases represents downside risk to labor markets and may accelerate the Fed’s easing cycle if conditions worsen.

Tariffs

Tariffs—taxes on imported goods—increase prices for consumers and businesses, reducing purchasing power and potentially slowing economic growth, while also disrupting supply chains, creating uncertainty, and inviting retaliatory tariffs that harm domestic exporters.

Tariffs directly increase U.S. government revenue, which the CBO estimates could reduce budget deficits by trillions over a decade, but this doesn't account for negative economic impacts like reduced growth, higher inflation, retaliation from other countries, and decreased productivity, which can ultimately offset or worsen the deficit by slowing the economy and trade, creating complex and debated effects. While customs duties surged in FY2025, contributing to a slightly lower deficit, the long-term budgetary benefits are uncertain and depend heavily on economic responses and whether tariffs are maintained.

The Congressional Budget Office (CBO) reported a $1.8 trillion US government budget deficit for fiscal year 2025, only $8 billion less than fiscal 2024.

Much of the tariff revenue collected could be reversed if the Supreme Court review considers them illegal and the government is required to refund billions of dollars in tariff collections to taxpayers.

Liquidity

In credit markets, abundant liquidity and tight spreads call for disciplined risk-taking, with a preference for higher-quality issues and selective exposure to securitized assets. Ultimately, success in the coming year will depend on careful security selection and the ability to adapt as economic, policy, and market conditions continue to evolve.

Credit spreads across corporate bonds, asset-backed securities, and mortgage-backed securities remain at or near historical lows, reflecting abundant liquidity and persistent yield-seeking behavior among investors. While corporate fundamentals are generally healthy and default rates remain moderate, compensation for credit risk is thin, leaving little margin for error.

Within investment-grade credit, even modest spread widening has the potential to offset an entire year of income. As a result, risk-taking in both investment-grade and high-yield markets is approached prudently, with a strong emphasis on issues that demonstrate superior business fundamentals and balance-sheet strength.

US Treasury Market

In Q4 2025, the U.S. Treasury market was generally stable, with 10-year yields around 4%–4.5%. Increased borrowing needs due to rising Federal debt put upward pressure on rates from higher supply. Shifting bank reserve levels, ongoing fiscal policy debates, and increased investments supported overall conditions despite looming fiscal challenges.

Increased U.S. government debt to GDP (near 100%) meant higher Treasury issuance, putting upward pressure on rates, as the debt limit was raised to $41.1 trillion in July 2025.

Demand for T-bills shifted bank reserves from abundant to ample, raising concerns about liquidity, as noted in the December 2025 FOMC meeting minutes.

Strong Q3 GDP (4.3%) and projected Q4 growth (5.4%) supported market conditions. The higher Treasury T-bill issuance impacted money market funds and bank reserves as the Treasury anticipates significant market issuance in early 2026.

Corporate Credit

The U.S. investment-grade corporate bond market enters 2026 in a markedly different environment compared to the previous year. After strong returns in 2025, driven by high coupon income and solid demand, valuations are now at historically rich levels. Investors face a landscape where steady income and capital preservation are prioritized over excess returns, requiring a careful balance between constructive credit fundamentals and emerging risks.

Investment-grade credit delivered strong returns in 2025, driven by coupon income, price appreciation, and tightening spreads. Looking ahead to 2026, price appreciation is expected to be limited, but income remains attractive. Demand from taxable bond funds, foreign investors, and insurance companies continues to be robust, although it may be challenged by rising issuance levels.

Valuations show that corporate spreads ended 2025 near multi-decade lows. There is increased dispersion across sectors and maturities. Healthcare, banking, and capital goods experienced spread tightening, while finance, technology, and utilities saw spreads widen.

Corporate bond issuance has accelerated. Demand remains strong, particularly from pension funds and foreign investors. Sector trends are diverging, with technology and utilities likely to see more issuance, while the banking sector may see less due to regulatory changes.

Fundamentally, credit conditions are broadly stable, with net leverage for investment-grade issuers nearly 2.9 times. Industrial margins are benefiting from productivity gains, including investments in artificial intelligence. However, risks remain, such as rising capital expenditure and acquisition activity, which could pressure credit metrics if funded by additional debt.

Sector highlights include banks potentially benefiting from regulatory relief and improved profitability, while utilities face increasing borrowing needs for infrastructure investment. Idiosyncratic risks persist in areas such as sub-prime exposures, private credit, and non-depository financial institutions.

FNMA and FHLMC

The government-backed housing finance giants have added billions of dollars of mortgage-backed securities and home loans to their balance sheets in recent months, as they try to push down lending rates and boost profitability ahead of a potential initial public offering. Fortunately, the rate reduction would also benefit consumers.

Asset Backed Securities

The Trump Administration is considering limiting the cap on credit card interest rates to 10%.  This would severely impact credit card issuers that have been enjoying usurious credit spreads.  Outstanding asset-backed securities with wider margins and reserves would appreciate in market value if this proposal is implemented.

Money Market Funds

As of December 30, 2025, US money market funds increased by $59.9 billion to $7.7 trillion, which is a significant increase from 2024, as reported by the Investment Company Institute (ICI). Assets of institutional money market funds were $4.66 trillion. Government funds were $4.42 trillion, prime funds were $222.1 billion, and tax-exempt fund assets were $12.4 billion.

The consistently high-interest rate environment, driven by the Federal Reserve's policies, has made money market funds more attractive than traditional bank deposits. Factors such as the regional banking crisis of March 2023, an inverted yield curve, and ongoing market volatility have contributed to the growth in money market fund assets.