Q4 2025 Short Duration Commentary

Overview

With highlights including another quarter-point cut in the federal funds policy rate at the Federal Reserve’s (Fed) mid-month Federal Open Market Committee (FOMC) meeting, a general upward drift in most asset markets and global interest rates tracking higher, December closed out an event-filled year. After all the trade policy noise and drama throughout the year, in the wake of the U.S. federal government’s longest ever shutdown that ended on November 12, publication of official economic data has been restored slowly, although gaps remain and inconsistencies have been observed, clouding how the economy is performing for market participants as well as Fed officials. Across fixed income sectors, spreads closed 2025 near the tights of the year and do not offer compelling opportunities, as we expect to see growing dispersion in subsector performance in credit as we move into the new year. Against a backdrop of growing fiscal policy support in 2026, we anticipate U.S. economic growth will remain solid enough, although a change in leadership at the top of the Fed, expected further challenges to its independence and pressure to lower its policy rate in the face of sustained above-target inflation could lead to renewed rate and market volatility. The extent to which the bond market’s willingness to continue readily financing sovereign borrowers with challenging fiscal outlooks may also be tested in 2026, which could be another source of market volatility or underappreciated risk.

Central Banks / Monetary Policy

The Fed delivered a widely anticipated 25-basis-point (bp) cut at its December FOMC meeting, shifting guidance toward a potential pause in early 2026. Chair Powell reiterated that tariffs remain the primary reason inflation is above target, underscoring the Fed’s cautious approach. Liquidity operations, specifically Treasury bill purchases framed as reserve management, began at the beginning of December and seemed to ease tightened liquidity conditions. The Bank of England also reduced rates by 25 bps on a close vote, while the European Central Bank held steady, and the Bank of Japan hiked its policy rate to 0.75%, a 30-year high, while emphasizing that real rates remain deeply negative, signaling that further rate hikes could follow. Thus, while the market expects the Fed may continue to ease monetary policy in 2026, policy divergence is emerging, as it appears other major central banks are done cutting and may be poised to lift rates in the new year. News of the Justice Department’s investigation into Chair Powell’s congressional testimony last summer on the Federal Reserve’s Washington building renovation project(s) injects a new element of political and market uncertainty, which could impact the administration’s ability to fill opening seats at the Fed, while in the short run, thwarting efforts to push interest rates lower.

The White House’s decision on a nominee to succeed Chair Powell now appears likely to be announced in January. Markets are looking for signals on whether the nominee will be perceived as independence‑minded or more aligned with the administration, as this could influence breakeven inflation rates, nominal yields and monetary policy in the coming years. In the event the market perceives the nominee for Fed Chair as more of a mind to carry out the administration’s stated desire to push the fed funds rate well below what the market is pricing or what the economic conditions and outlook warrant, the Fed’s credibility could be threatened. Under such a scenario, we believe the bond market would push long-term yields higher, contravening the administration’s aim to support economic growth by bringing down interest rates to stimulate economic growth.

Economic Growth, the Consumer and Fiscal Policy

Economic activity appeared to conclude the year with decent momentum on the heels of the U.S. government’s shutdown, which did not seem to ruin the holiday selling season. The most recent retail data from the government dates from October, indicative of officials playing catchup, and showed headline sales were flat due to autos and gasoline, while the control group rebounded strongly (+0.8% month over month in October’s delayed release) and high-frequency indicators, such as credit and debit card transaction data, showed healthy holiday spending through mid-December, led by non-store retailers. However, headwinds are evident with higher-end consumers seen as carrying an increasing share of the load in terms of growth, helped by the wealth effect driven by another strong year for equities and even higher returns seen in commodities and other assets. Conversely, apart from that wealthier cohort, other U.S. consumers are facing more challenges mainly due to low real income growth and inflationary pressures on essential goods and services, such as in the grocery aisle, which have shown up in the slide in consumer sentiment indicators since the summer and deteriorating metrics, such as growing delinquencies. Looking ahead, additional fiscal stimulus from the One Big Beautiful Bill Act (OBBA) should provide temporary support early in 2026, though its impact may be uneven across income segments.

Business / Labor Markets

Data released in December on labor market conditions showed softening. Headline October nonfarm payrolls were –105,000 and November nonfarm payrolls were 64,000, bringing the three-month average to 22,000, well below historical norms. Recent strength has been concentrated in healthcare and education, while cyclical sectors have lagged. November’s unemployment rate rose to 4.6%; however, some of this deterioration may reflect previously noted shutdown-related data issues rather than a sudden drop in underlying worker demand. Overall, the prevailing dynamics evident since mid-year of low hiring and low firing appear to remain in place, with a return to stronger economic growth in 2026 more reliant on a boost from fiscal policy and inflation turning and moving closer toward the Fed’s 2% target.

Despite large companies demonstrating another quarter of solid earnings growth and pointing toward continued optimism for 2026, smaller and mid-sized companies are experiencing greater challenges from the impact of tariffs and weaker consumer income dynamics. Despite large companies’ solid top-line growth and resilience, they are expected to continue to remain very cautious around hiring, with AI-driven spending and investment continuing to be key drivers of economic growth, which could represent a market vulnerability if growth plans do not come to fruition.

Inflation

November’s inflation reading(s) delivered a mixed message and perhaps most clearly reflected the impact of some of the gaps in data government statisticians are working with as they publish official data. Headline CPI slowed to 2.7%, year over year, and core CPI slowed to 2.6%, surprising markets on the downside. However, these figures were likely distorted by the government shutdown, which probably understated true price pressures. Core PCE, the Fed’s preferred inflation gauge, remained sticky at approximately 2.8%, signaling that the battle to bring underlying inflation to heel is far from won. Super-core services inflation (excluding housing) continues to run hot, driven by laborintensive sectors and healthcare, reinforcing concerns about structural stickiness. Goods inflation eased modestly, but tariff-related cost pressures remain a wildcard, particularly for import-heavy categories. Market pricing reflects skepticism about a rapid disinflation path, with expectations that the Fed will tolerate inflation above target while prioritizing growth stability. Forthcoming fiscal stimulus from the OBBBA may temporarily boost growth and inflation, raising the risk of renewed price pressures in the second half of 2026.

We remain watchful regarding the sustainability of softer inflation prints and will monitor whether tariff-related cost pressures re-emerge as fiscal stimulus lifts demand. Particular focus will remain on Owner’s Equivalent Rent (OER), core goods categories and indicators such as PMI and ISM price indexes for early signs of input cost acceleration. In addition, sectors with high import exposure and discretionary goods will be monitored for renewed margin stress, as these areas are most vulnerable to shifting trade dynamics and potential second-half inflation reacceleration.

Geopolitical Environment

Heading into the new year, the geopolitical landscape is an area with many crosscurrents that could jolt markets or represent sources of tail risk, while influencing the macroeconomic landscape. U.S.- China trade tensions and tariff-related uncertainties persist, while the U.S. administration seeks to reshape long-standing economic and political relationships (such as with the EU and NATO) and broker peace to address some enduring conflicts and newer clashes such as the seemingly insoluble Russia-Ukraine war. As policymakers consider changes to trade agreements and tariff structures, market participants are paying close attention to the potential impact on global supply chains, input costs and overall risk appetite. The U.S.’s apparent efforts to force a change in Venezuela’s government and some of the other hotspots impact energy markets and could influence whether low energy prices, a key element of maintaining low inflation, will continue.

Near-Term Outlook: Constructive on Interest Rates, Cautious on Spreads

As we move into 2026, our outlook for fixed income markets is constructive but measured. The Federal Reserve’s December rate cut and its hawkish pause signal have created opportunities at the front end of the yield curve. However, stress in private credit markets and uneven consumer dynamics call for careful credit selection. In this environment, generating income through carry will be a key driver of returns over the near-term, reinforcing our defensive posture and preference for higher-quality assets.

In investment grade credit, we continue to emphasize issuers with strong fundamentals and limited cyclical exposure, favoring sectors such as banking, insurance, communications, consumer staples and electric utilities and prefer senior positions in asset-backed securities (ABS) and residential mortgage-backed securities (RMBS) backed by prime collateral. Within the mortgage space, continued growth in the government sponsored enterprise’s (GSE) retained portfolios should support agency MBS, though prepayment risk and policy uncertainty could weigh on valuations. We plan to selectively add exposure, focusing on pools that offer structural protections, such as seasoned loans or smaller balances, rather than more generic alternatives.

We continue to favor a “bulleted” yield curve posture and a slightly long duration bias, positioning portfolios to benefit from stable or declining interest rates, while also preserving the flexibility to respond to policy shifts or geopolitical developments. Overall, we believe that carry and disciplined credit selection will drive returns in the early part of 2026, with incremental opportunities likely to emerge as valuations normalize. We will continue to emphasize quality and liquidity across all our portfolios.

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