Quarterly fixed income outlook: April 2025 | Insight Investment

While the world awaits what will occur as President Trump’s 90-day delay in the imposition of tariffs ends, the outlook for growth remains soft. Another extension could help achieve more trade agreements being successfully reached. Lowering tariffs to trade-liberalising levels is likely to be a challenge and may only be possible if concessions are provided to the US. While recession is not the primary expectation, it remains a clear and non-negligible risk in many countries. Tariffs and whether/when they are imposed will continue to complicate the inflation picture, given the difficulty in knowing how reciprocal actions may affect individual countries. We see the downward trend continuing slowly, supported by the weak growth outlook, but there are likely to be periodic volatility, which could be exacerbated if trade wars escalate. The major central banks are expected to ease rates further but not by much and the European Central Bank may only have one rate cut left to implement if market expectations are met. Meanwhile, Japan faces the opposite scenario as the Bank of Japan is expected to continue slowly raising rates to combat inflation and wage growth. 

The uncertainty surrounding the outlook for the US economy remains relatively high as the 90-day pause on the implementing widespread import tariffs approaches. Forward-looking indicators are broadly neutral offering little meaningful guidance on future direction. We believe that an economic slowdown should be expected following the more robust momentum seen in 2024 and early 2025. GDP is expected to expand by 1.4% in 2025 and just 1.2% in 2026. Although recession is not our central case, we see it as a clear risk and believe that the labour market is likely to ease as activity softens. Meanwhile, the trend in inflation is still downward, though only gradually, with volatility likely to be precipitated by the uncertain backdrop of tariffs. We expect CPI to be just below 3% in 2025, easing modestly towards 2.5% for 2026. There is elevated risk that an escalation in the trade tensions could undermine the downward trend in inflation more substantially and cause to reaccelerate. While the Federal Reserve has maintained interest rates unchanged since December 2024, we do expect further rate cuts over time, supported by the labour market being less tight. We see the terminal Fed funds rate at about 3.25% some time in 2026. Any detrimental effects the President’s flagship One Big Beautiful Bill could have on the deficit and debt level may begin to have greater influence the level of Treasury yields. Our expectation is that the yield curve will steepen modestly from current levels with shorter dated Treasury yields declining more than longer maturities. We see 10-year Treasuries at 3.85% in a year’s time.

In the eurozone, economic growth is likely to struggle to exceed 1% in 2025 and could soften further in 2026. While there is stronger recovery in Spain, core countries like Germany and France continue to struggle. The effects that US tariff may have on growth are not clear, but the manufacturing sector has already been struggling and could face further headwinds if no trade deal is agreed. Inflation is expected to move broadly sideways, having reached the 2% target level, and we now expect the European Central Bank to ease policy further later in 2025, taking the deposit rate down by a further 25bp, which we believe will be the trough for this cycle in the absence of a further disruptive event. Agreements to ramp up defence spending and in some places increase infrastructure spending too, could help boost growth over time, but also put pressure on deficits. We have modestly increased our forecasts for German government yields, seeing 10-year yields at 2.65% in a year’s time, and longer-dated yields at 3.25%.   

Prospects for GDP growth in the UK are well below trend, but largely in line with the US and eurozone. We expect modest expansions of about 1.1% in both 2025 and 2026. The trade agreement with the US could help reduce uncertainty for some sectors but business sentiment is still underwhelming. The labour market may be softening and with wage growth beginning to ease, inflationary pressure could abate further, while house price growth is at best, only modestly positive on a year-on-year basis. We see inflation remaining fairly sticky at around 3.2% for 2025, before continuing to move down to 2.3% in 2026 as it approaches the 2% target level. Although the Bank of England is seen as a relatively dovish institution, our expectation is for UK policymakers to only gradually continue to ease rates further, with two further 25bp cuts taking the base rate to 3.75%. We do not anticipate gilt yields moving substantially lower from currently levels in the next year but have increased our forecast for 10-year yields slightly to 4.60%. 

China continues to face the problems of having excess slack in its domestic economy at the same time that threat of tariffs from the US puts pressure on its external sector. The drag from the property sector remains as house prices continue to decline. We expect GDP growth to undershoot the 5% target level in 2025 and 2026 at about 4.5% and 4% respectively. Inflation is expected to increase and reach 1% this year and 1.3% in 2026.  We do not expect any further significant reductions in short term interest rates as the authorities try to use other methods to stimulate activity. We forecast bond yields to increase in the next year, more so at longer maturities, with the 10-year yield rising to 2.10%.

The picture across other emerging markets remains mixed. Inflation concerns combine with uncertainty about the effects of US tariffs to keep pressure on central banks. The monetary tightening in Brazil may be approaching its peak if inflation can continue to ease, while many other central banks are likely to remain on the broad easing tack that is in place. There are plenty of potential pitfalls for emerging market countries, particularly those with extensive exposure to the US. 

Credit markets are navigating a delicate balancing act, with improving fundamentals, such as declining corporate leverage in Europe and strong demand in the US, offset by expensive valuations relative to history and macroeconomic uncertainty. The widening in spreads that occurred around the tariff-related turbulence led us to become more constructive on investment grade credit markets from a valuation perspective, but this has largely reversed, and we would become cautious if the current trend towards tighter credit spreads continues. We are conscious of the risks stemming from heightened geopolitical tensions and the looming impact of tariffs on the broader economy. In the US, absolute yields remain attractive, though earnings pressure and waning international demand are concerns. In Europe, upgrades are outpacing downgrades and fiscal support from Germany should provide a tailwind and help to offset the negative impact of tariffs.  Valuations remain more attractive on an historical basis versus peers but are still tight enough to somewhat temper exposure. Overall, this leaves us with a cautiously constructive view, favouring selective exposure and higher quality issuers with a modest bias towards Euro denominated debt where appropriate.

Demand continues to be dominated by investors looking to lock in the high absolute level of yields, with any sell-off in spreads being seen as an opportunity to add to positions. Tariffs, and their broader impact on growth, remain a concern, and require careful consideration as we make new investments within active portfolios. However, many high yield companies manufacture and sell locally which helps to mitigate the impact. Although we expect growth to slow, we believe the US remains well placed to avoid recession. In Europe, the German fiscal expansion and front-loaded easing from the European Central Bank should underpin growth in the years ahead. Regulatory shifts are also expected to ease capital access for previously constrained industries such as defence. Overall, we continue to believe the environment remains attractive for high yield companies, many of which boast strong balance sheets and robust cash flows. Defaults remain low, and this likely represents a structural shift for high yield markets, with smaller and distressed issuers turning to private credit markets where there is far greater flexibility to restructure debt when necessary.

We still see small pockets of value in local emerging market debt. We continue to own Colombia and Brazil where rates are historically high, but we have also added new issues local in Peru and Argentina. We are also starting to see an improved technical picture for the asset class, as investors from China, South Korea and Taiwan reduce their exposure to US assets and shift to locally issued debt. We have a preference for high yield over the investment grade universe, which appears to be relatively expensively priced. We are taking more risk in emerging market corporate debt due to spreads being attractive relative to the median, as well as there being net negative issuance alongside inflows from investors shifting out of US assets.

The market experienced some volatility around the announcement of US tariffs, with spreads widening as risk assets sold off more broadly. Issuers stepped back from primary markets in reaction to the deterioration in market conditions and the lack of new supply helped stabilize markets. This pattern, where issuers step back as volatility rises and return as conditions improve, has become a structural feature of markets, helping to dampen spread volatility. The introduction of tariffs has delayed expectations for Fed rate cuts and with coupons linked to short-term rates this should result in higher levels of income than previously anticipated through the rest of 2025. We continue to be active in primary markets, capitalizing on new issue premium and more broadly seeking out relative value opportunities that offer attractive risk-reward profiles. Our preference remains for issues with seniority in the capital structure and robust transaction structures that divert cash flow in the event of underperformance in the underlying asset pool. Strong underwriting and servicing policies should also act to insulate investors if the economy unexpectedly weakens.

Our 2025 outlook calls for a softening US economy, but with growth not sufficiently weak for the economy to dip into recession. The heightened uncertainty surrounding the new Trump administration’s policies, some of which may be inflationary, is likely to keep pressure on longer maturity rates. Municipal yields should follow the trend in Treasuries with the prospect of further yield curve steepening. We continue to favor sectors like public power and water/sewer utilities for their stability, essential nature, and predictable cash flows. In contrast, we have moved underweight on lower-yield sectors such as state and local general obligation and pre-refunded bonds. Credit spreads remain tight but could compress further amid strong fundamentals and steady demand. We see continued value in airport and toll road credits due to travel recovery, while mass transit, healthcare, and higher education face structural challenges. Our preference is for large, diversified issuers with strong balance sheets, especially given rising climate-related risks.

Longer-term factors, such as valuations and fiscal concerns, have been a headwind for some time, but the USD has been supported by ‘US exceptionalism’. We believe there is a risk that President Trump’s policies may undercut that appeal and lead to lower capital inflows to the US. In addition, policy uncertainty and a more aggressive America First agenda could erode the cyclical support for the USD, leading to an extended period of weakness. However, real rates may remain high until there is evidence of economic weakness that concerns policy makers sufficiently. As growth outside the US is expected to remain sluggish at best, we think it would be prudent to exercise caution about being overly short USD particularly as we believe the speculative community may still be significantly short USD.