Tiffany Wilding

Markets and observers weren’t surprised when the Federal Reserve held its policy rate steady at the April meeting. More notable, in our view, were the three dissents by voting participants who did not support keeping the implicit easing bias in the policy statement’s forward guidance language. We presume their preference would have been a stronger signal that the next interest rate move, whenever it occurs, could be either a hike or a cut.

Our view remains that the next move will be a rate cut, but the timing is far from clear. 

Chair Jerome Powell’s press conference emphasized the wide range of possible outcomes associated with the Middle East conflict, along with generally high uncertainty. He suggested that changes to the statement were a close call – more committee members supported more hawkish changes than during the previous meeting in March. Powell also argued that Fed policy is in a good place to react to the economic implications of the energy supply shock, which poses risks to both sides of the Fed’s dual mandate: maximum employment and price stability. 

Markets thus far seem to have interpreted the Fed’s signals as a hawkish shift, though the reaction seems tempered by expectations that Kevin Warsh, the incoming Fed chair, will be able to keep the Fed on hold despite stagflationary pressures from the Middle East conflict.

We still think there is a high bar for the Fed to reverse course and hike rates. Given the significant uncertainty over energy prices and energy supply (for details, read Macro Signposts, “Temporary Disruption – or the Start of a Global Supply Shock?”^[1]), the Fed is likely to hold rates steady until it sees the inflation/unemployment trade-off becoming clearer.

Why the tone skewed a bit more hawkish

With the Fed widely expected to be on hold, the meeting was always going to be about communications. The statement kept its implicit easing bias – which garnered the three dissents – while Governor Stephen Miran continued his pattern of dissenting in favour of easier policy.

The easing bias in the statement is subtle and centers around the forward guidance sentence: “In considering the extent and timing of additional adjustments to the target range for the federal funds rate …” The word “additional” in this context has been interpreted to mean additional cuts. The dissenters would have presumably preferred to more strongly suggest that the next rate move could be either a cut or a hike – we see a hawkish (or at least less dovish) leaning implied in their dissents. That forward guidance language could be changed or removed as soon as the next meeting, if developments warrant it.

At the press conference, Powell articulated a modest shift in Fed views in a more hawkish direction. In practice, this likely translates to a period of holding rates steady until the economic data, outlook, and balance of risks paint a clearer picture for the policy path.

Baseline still implies cuts, but timing looks more conditional

Despite all of this, we still expect the next rate move will eventually be a cut, and we still pinpoint roughly 3% as the neutral policy rate. However, the timing is uncertain. If the Iran conflict and energy shock appear more persistent, it could take longer for core inflation to more clearly begin to moderate back toward the Fed’s target, complicating the decision to ease monetary policy.

Many observers and policymakers remember the pain of the sharp inflation spike in 2021–2022. We see important differences between now and then that should help mitigate core goods price inflation spillovers into broader services categories. The widespread inflation during the post-pandemic episode was also related to large fiscal transfers (such as federal spending packages to support households and businesses) and compounded by an extremely tight labor market – factors that aren’t present today. 

Eventually, as energy prices moderate (assuming they do), the Fed could still cut a few more times to align the current policy range of 3.5%–3.75% with the Fed’s median estimate for neutral policy of roughly 3%.

On the other hand, in a risk scenario where there is a more prolonged disruption in physical energy supplies out of the Middle East, the trade-offs look starker. Even though the U.S. is relatively insulated as a net energy exporter, the higher global recession risks, and likely tightening financial conditions, would eventually lead to rate cuts, in our view – although an initial surge in global inflation would likely delay the central bank’s reaction to weaker activity.

Warsh transition unlikely to shift policy outlook

This was likely Jerome Powell’s final meeting as Fed chair. He committed to staying on as a governor until the legal investigations into him and the Fed building renovation costs were over with “transparency and finality.” He also said that Fed officials should be able to “make monetary policy without political considerations.” He did commit to stepping down, but his comments leave plenty of room for interpretation on when he might feel comfortable with leaving. He also committed to maintaining a “low profile” as a governor and to aiding soon-to-be Chair Warsh where he can.

Powell also shared that Fed officials are worried about a continuation of challenges against the Fed or its people, and he specifically noted that the removal of Federal Reserve Bank presidents due to policy choices would be “the beginning of the end.”

In our view, the Warsh transition should mainly affect Fed communication – and market interpretation – rather than interest rates themselves. Warsh did not seem overtly dovish in his Senate hearing. Indeed, he criticized the Fed for being late to act on inflation in 2022. He did point to trimmed mean and median inflation measures, which are currently running under core personal consumption expenditures (PCE) inflation – a modestly dovish lean. These measures have historically tended to run above core inflation and will likely accelerate if higher energy prices broadly push core goods inflation higher.

Our working assumption remains that Warsh’s current bias (similar to the Fed’s median) is toward cuts, and that the Fed will remain an independent institution under his watch.

By Tiffany Wilding, Economist

 ———-

Notes:
[1] “Temporary Disruption – or the Start of a Global Supply Shock?”)

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Tiffany Wilding

U.S. headline employment rebounded strongly in March, posting the largest monthly gain since late 2024. The jobs rebound, which was broad-based across industries, was a welcome sign after February’s data showed a sharp decline not usually seen outside of recessions. Weather-related disruptions and a healthcare workers’ strike likely contributed to the monthly volatility.

Beneath these swings, however, we’re seeing a more consequential shift: Structural changes in the U.S. labor market are changing the composition of U.S. real GDP growth – and therefore changing how we should interpret labor market data when assessing the broader health of the economy.

More restrictive U.S. immigration policies along with long-running demographic trends are reducing labor supply growth and employment trends essentially to zero. This means that the U.S. economy now relies solely on real productivity growth to maintain its 1.5% to 2% trend in overall GDP growth – an unprecedented dynamic.

In the near term, stagnant labor force growth will likely provide a strong incentive for businesses to invest in labor-saving technology. Indeed, AI investment and implementation accelerated dramatically in 2025, and investment trends are likely to remain strong. In terms of monetary policy, weaker headline payrolls figures aren’t likely to garner the reaction they have in the recent past, as larger and more sustained employment contractions are now needed to increase the unemployment rate.

Over the medium term, economic growth may largely depend on how quickly and effectively AI implementation can contribute to sustainably higher productivity growth. At this point, AI’s trajectory is an open question. Without a significant boost from AI, stagnant labor force trends could eventually lead to lower investment, slower growth, and lower rates.

Declining size of the U.S. labor force

At its most basic level, real GDP growth can be broken down into two factors – growth in aggregate hours of employed labor (which depends on population and labor force trends) and the productivity of workers during their hours worked. Changes in labor force growth – or those individuals who are currently employed or looking for a job – will have important implications for broader growth trends.

Since the 1960s, trend labor force growth in the U.S. has shifted due to demographic trends. At its peak in the 1970s, trend labor force growth was 2%–3% per year as more women joined the workforce and as both men and women from the post-WWII baby boom reached working age. Since then, labor force growth has slowly declined along with fertility rates, and the aging population has meant more retired workers – see Figure 1.

These demographic trends left the U.S. increasingly reliant on net immigration to sustain labor force expansion. Over the past decade, foreign‑born workers accounted for roughly half to two‑thirds of net U.S. labor force and employment growth – nearly all of it in the post‑pandemic period.

Humanitarian immigration – mainly asylum seekers – surged in the wake of the pandemic and contributed to a reacceleration in U.S. labor force growth from 2022 to 2024. More recent policy changes have not only reduced the inflows of immigrants, but also increased the outflows. Research by Wendy Edelberg and other labor economists at Brookings1 has found that net migration was likely close to zero or negative over calendar year 2025 and is very likely to be net negative in 2026.

Changing U.S. growth composition

Unless immigration policy returns to a less restrictive stance, labor force growth will likely remain stagnant or even decline. Recent Federal Reserve staff research2 highlights two important implications: First, near-zero labor force growth implies that average monthly job gains needed to keep the unemployment rate stable are also near zero – making negative job growth as likely as positive in any given month. Second, growth in potential GDP is likely to depend entirely on productivity gains.

In its latest economic outlook, the U.S. Congressional Budget Office (CBO) projected the trend in productivity growth to be 1.5%, while under pre-pandemic immigration policies the trend labor force growth was 0.5%. Combining these components left trend real GDP growth at 2%. If labor force growth is now zero, that should mechanically lower trend GDP growth as well – see Figure 2.

Why the productivity offset is not automatic

It may not be as simple as adjusting trend growth down by the now lower contribution of the labor force. An economy generating moderate productivity growth with little or no labor force expansion would be historically rare, in part because labor and capital trends are linked in two important ways:

First, production of goods and services requires both people and tools. Capital makes labor productive and labor makes capital useful. More specifically, people (labor) do the work, but how much they can produce depends on the tools, machines, software, and structures they have to work with (capital). Higher productivity growth requires continued investment in capital per worker, but the extent to which labor makes capital useful tends to diminish at higher levels of investment. As a result, stagnant labor force growth could eventually slow investment and productivity trends.

Second, the economy needs a stream of new ideas to guide productivity-enhancing investments, and people generate those ideas. As Paul Romer asserted in his 1990 paper,3 new ideas are the heart of economic growth because ideas are “non-rival” – no matter how many people use the idea, there is not less of the idea to go around. If more people are participating in the labor market, then there are more people who can use old ideas to create new ones, which in turn can drive investment and future productivity. With fewer people, the pace of innovation could slow, reducing investment in future productivity growth.

Artificial intelligence to the rescue?

AI offers the potential to support continued innovation that drives investment and future productivity growth, despite a stagnant labor force. Unlike past technologies that have given humans faster and better tools, AI also has the potential to replace humans across a range of tasks, including new idea generation. To the extent that AI is a substitute for labor (in addition to complementing it), it could also at least in theory drive sustainably stronger capital deepening trends for a time.

Companies are racing to implement AI in hopes of transforming their businesses in ways that increase productivity and efficiency. However, the timing and magnitude of the productivity gains are highly uncertain. In the near term, if AI-driven productivity is slow to materialise, then consensus expectations for above 2% U.S. growth over the next several years are likely too high. In the medium term, low labor supply increases the burden on AI (or other technologies) to maintain recent trend growth levels.

Bottom line

With labor force growth grinding to a halt, job gains no longer carry the same signal they once did. Investors should expect the frequency of monthly employment contractions to increase as the U.S. job market adjusts to limited labor supply.

The U.S. economy is increasingly reliant on productivity. That makes AI not just a cyclical force, but a structural one that shapes investment, productivity, and long-run growth prospects.

For the medium-term outlook, this is yet another layer of uncertainty that increases the attractiveness of high quality bonds as a generally stable source of income and store of value.

By Tiffany Wilding, Economist

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Overall, China’s economy must deal with excess economic capacity by stimulating domestic private activity or set growth targets at lower levels that strictly contain production.

China’s ability to sustain fairly robust economic growth despite a massive property sector downturn is now facing new tests as global trade barriers rise, and domestic demand shows fresh signs of weakness.

Looking ahead, China’s excess industrial capacity and mounting inventories are likely to intensify deflationary pressures – forcing policymakers either to further stimulate domestic consumption or to tolerate slower growth. The readout from China’s recent fourth plenum acknowledges this economic reality. However, how quickly China can shift its growth model inward remains a key question.

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Tiffany Wilding

Despite heightened political noise surrounding the Federal Reserve, we do not anticipate dramatic shifts in monetary policy – regardless of who is confirmed as the next chair. A Trump-appointed candidate would likely favor a faster return to a neutral policy stance than the current median view of the Federal Open Market Committee (FOMC). They may also support a more aggressive approach to balance sheet normalisation, with an emphasis on gradually shifting the Fed’s holdings toward Treasury bills.

While Trump’s nominees for Fed chair would likely advocate for a faster pace of rate cuts, the administration’s optimistic growth forecasts limit the case for a policy stance below neutral or for adopting a much lower estimate of the neutral rate than the current FOMC consensus.

Furthermore, despite ongoing speculation, we believe it is highly unlikely that Trump will fire Fed Chair Jerome Powell before his term ends in May 2026. Firing Powell could be self-defeating in several respects, and besides, the legal, political, and economic ramifications loom too large. (For a more detailed analysis, see the article by my colleague and former Fed Vice Chair Richard Clarida in last month’s Economist, titled “The best check on Fed politicisation is fear of being judged a failure.”)

Overall, we believe a reasonable path forward given our economic outlook is a return to a neutral policy stance by the end of 2026, with interest rates settling near the midpoint of the Fed’s estimated neutral range of 2.6%–3.6% (down from the current level of 4.25%–4.5%). This is lower than the FOMC’s current 2026 Summary of Economic Projections median projection of 3.6%, but it remains within the central tendency range. So far, consumer price adjustments resulting from higher tariffs have been mild. If that trend continues, there is a strong case for the Powell-led FOMC to resume normalizing rates later this year.

Interest rates could reach neutral next year

Many investors are asking about the direction of Fed policy, particularly in light of Trump’s public dissatisfaction with recent decisions under Powell and next year’s expiration of key Fed appointments. In our view, economic fundamentals and institutional dynamics point to a baseline monetary policy outlook that is not meaningfully different from what would be expected with the current composition of FOMC participants – perhaps with a marginally faster return to a more neutral policy stance.

Amid the headlines surrounding Trump and Powell, recent economic data developments are strengthening the case for rate cuts. U.S. economic momentum has slowed compared to last year: Department of Commerce data show real consumption growth of approximately 1% in the first half of 2025, down significantly from the 4% pace recorded in the second half of last year. Inflationary pressures have also been milder than expected – partly because tariffs are taking time to filter through to consumer prices (see last week’s Macro Signposts, “The Economic Impact of U.S. Tariffs”^[1]). Some policymakers, including Fed Governor Christopher Waller, have made a case for an earlier move in July, while 10 FOMC participants expect two or more 25 basis-point cuts later this year.

The individuals speculated to be leading contenders to succeed Powell as Fed chair – including Waller, Kevin Hassett (Director of the National Economic Council), and Kevin Warsh (former Fed governor) – would likely advocate for faster and deeper rate cuts. Assuming sufficient consensus, the FOMC could potentially lower rates by 100 to 150 basis points (bps) from the current range of 4.25%– 4.5%.

However, this would not represent a radical departure from current policy; it’s at the lower end of current Fed estimates for the neutral rate. Thus, by cutting rates at a steady pace, the Fed under Powell could potentially reach neutral before a new chair is appointed.

Much hinges on the Fed’s estimate of neutral – and whether a Trump-nominated chair would argue for a level below the current central tendency range of 2.6 to 3.6%. While supply-side expansion could help limit inflationary pressures, higher supply-side growth is typically associated with elevated investment, which tends to raise the neutral rate. If such growth materialises, it would be difficult to justify a policy rate significantly below the Fed’s estimated neutral range.

In our view, the case for a much lower neutral rate appears inconsistent with the Trump administration’s optimistic growth projections. Both Hassett and Warsh have said that Trump’s tax and tariff policies could lift U.S. real GDP growth to around 3%.

Moreover, even if a Trump nominee pushes for a much faster return to neutral, the Fed, as always, makes policy decisions by committee. It would take more than one or two votes to sway policy dramatically away from a steady, measured return to neutral.

Why Fed Chair Powell will likely serve his full term

Despite persistent rumours and occasional threats from the president, we still believe it is highly unlikely that Trump will move to fire Powell before his term ends in May 2026. There are compelling legal, political, and practical reasons for this view.

• Legal constraints: The most significant barrier to removing Powell is legal. Earlier this year, the Supreme Court affirmed the Federal Reserve’s special status as a quasi-private institution, whose governors can only be removed for “cause” – a high threshold typically reserved for serious misconduct such as fraud. While some Republican lawmakers have tried to build a case for removal by pointing to cost overruns in the Fed’s building renovations, the Federal Reserve Board has quickly responded with reasonable rebuttals. Powell has also called for an independent Inspector General review and privately indicated that he would challenge any attempt to unseat him – likely remaining in his position while the matter is litigated.

• Political realities: Even if Trump could legally remove Powell, doing so would be politically risky and likely counterproductive. All Fed nominees require Senate confirmation, starting with the Senate Banking Committee. Given the current political landscape, it could be difficult for Trump to secure unanimous support from Republican committee members, especially if the move is perceived as an attack on the Fed’s independence. In the committee, a single Republican vote in opposition could derail a nomination. Two GOP members of the Senate Banking Committee, Thom Tillis and John Kennedy, have said that firing Chair Powell should be avoided, with Tillis saying it would “undermine the credibility of the U.S.”. Like his predecessors, Trump – in his first administration – struggled to advance controversial Fed nominees, with several high-profile withdrawals and failed confirmations in recent years.

• Economic and market consequences: Firing Powell could carry significant market risks. Past speculation about his potential removal has led to higher long-term interest rates and declines in equity markets – outcomes contrary to the administration’s goals. Leading economists and former Fed officials have warned that such a move could undermine confidence in the central bank, raise inflation expectations, and call into question the unique global status of U.S. capital markets. The likely consequences: steeper yield curves, higher rates, and a weaker dollar.

• Institutional checks: Finally, as noted above, it is important to remember that the Fed chair holds only one of 12 votes on the policy-setting FOMC. Even if Trump were to install a politically partisan chair, it is far from certain that the rest of the committee would support a dramatic shift in policy. It’s worth noting that of the current seven-member Fed Board of Governors – all of whom vote in the FOMC – only two were nominated during Trump’s first term, while the others were nominated by President Joe Biden.

Bottom line

Over the next few years, barring an unexpected negative economic shock or more concerning underlying inflationary pressures, we expect a steady return to a neutral monetary policy stance – first under Powell’s leadership through May, and then under the next Fed chair. Fed independence, combined with economic fundamentals and institutional checks, supports this baseline outlook.

In the near term, while Trump is likely to continue criticising the Fed and advocating for lower rates, we do not expect him to attempt to fire Powell. Instead, Trump will begin shaping the Fed through upcoming appointments, beginning with the expiration of Governor Adriana Kugler’s term in January and Powell’s chairmanship in May (Powell’s term as governor, distinct from his role as chair, runs through January 2028).

Whoever Trump chooses as next chair will, like any Fed leader, have to present a credible case for monetary policy decisions that garners Senate confirmation first and then a majority FOMC support. As with other institutions of the U.S. governing system, the Fed is structured with built-in checks and balances that limit the ability of any single individual to dramatically shift its policy trajectory.

By Tiffany Wilding, Economist, (with contributions from Libby Cantrill, head of public policy).

———

Notes:
[1] “The Economic Impact of U.S. Tariffs”

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With stock valuations and volatility unusually elevated, and credit spreads tight, high quality fixed income can offer attractive yields, stability, and a robust longer-term outlook for patient investors.

At a time of sweeping geopolitical change and clear challenges for riskier assets, bond markets offer a source of stability.

Key takeaways

The world has entered a period of geopolitical uncertainty, with the U.S. now at the center of the storm. Here are our near-term economic views:

• Global uncertainty: The Trump administration has taken aggressive early measures to address trade deficits and shrink the size of government. It remains unclear whether the current policy volatility will evolve into a more stable U.S. strategy. As tariff barriers rise, global uncertainty is increasing, particularly for export-dependent economies.
• Threats to U.S. exceptionalism: With both business and consumer confidence declining, the U.S. economic and financial-market exceptionalism of recent years could be fading.
• National interests take new precedence: Protectionist U.S. policies, coupled with the prospect for government spending cuts, are stoking concerns about U.S. recession risks and a rekindling of inflation. In contrast, the prospect of increased fiscal spending is improving the outlooks for countries such as Germany and China. Major central banks will aim to continue easing policy to neutral levels.

This newfound U.S.-led uncertainty has fueled a sell-off in risk assets and a surge in volatility. Meanwhile, high quality bonds have flourished, delivering comparable total returns to equities over the past year while offering favorable valuations today. Here are our near-term investment views:

• Seek stable sources of return in turbulent times: Historically, starting bond yields closely correlate with five-year forward returns. Yields are attractive today, positioning bonds well in this environment. We believe it’s a good time to reduce concentrated positions in U.S. risk assets, particularly with valuations still elevated.
• Diversify across global markets: Global fixed income opportunities remain robust, offering strategies to further enhance diversification.
• Favor asset-based finance over corporate credit: We prefer asset-based finance relative to corporate credit across public and private markets.

Economic outlook: Global reordering

Pandemic disruptions are behind us. Labor markets have normalized. Although inflation in developed market (DM) economies may linger above post-financial-crisis averages, it’s broadly within reach of central bank targets. Monetary policy is gradually returning to more neutral levels.

The focus has turned to a new disruptor: U.S. policy. The Trump administration, elected on a platform of change, is pledging to pursue three interconnected goals that will reshape the U.S. and global economies:

• balancing the U.S. trade deficit (see Figure 1)
• reducing elevated fiscal deficits
• reversing the decades-long decline in the U.S. labor force’s share of income.

Correcting these imbalances would require structural changes, including curbing the share of GDP derived from consumption in the U.S., reducing the contribution to GDP from manufacturing and savings in trade surplus economies, and lowering the concentration of global excess savings flows entering U.S. capital markets.

Implementing these changes faces economic, political, and market constraints, both in the U.S. and abroad. Doing so over a six- to 12-month cyclical horizon would likely disrupt economies and markets, even if the result is eventually a more balanced global system.

We anticipated such disruption in our January 2025 Cyclical Outlook, “Uncertainty Is Certain.” Policy uncertainty is now unfolding daily and emanating mainly from the U.S., historically a source of global stability.

Threats to U.S. exceptionalism

This shift reflects an international role reversal, with the U.S. signaling a pullback from some traditional functions while other countries step in to fill the voids. Long-held assumptions about the U.S. as a reliable international leader are being challenged.

These changes may coincide with the twilight of the recent U.S. capital markets outperformance relative to the rest of the world. In Europe, the peace dividend – the economic benefits of reduced military spending after the end of the Cold War – looks to be over, with countries across the continent now set to increase their defense budgets.

In January, we said our baseline called for an economically manageable increase in tariffs – which, along with U.S. tax and spending policy, would leave federal fiscal deficits largely unchanged in 2025 and 2026.

However, we also said these pivots, depending on their scope, widened the range of possible growth outcomes in the U.S. and deepened economic risks elsewhere, especially for countries heavily reliant on global trade and that run surpluses with the U.S. We thought U.S. equity market volatility would be a limiting factor.

The Trump administration has since launched aggressive measures on trade, government containment, and immigration. These are likely to slow the U.S. economy more than previously expected and hurt the labor market, regardless of whether government spending cuts are codified into law.

Officials have argued that some near-term pain is acceptable in pursuit of longer-term goals, suggesting the tolerance for economic and market volatility is higher than previously thought. Eventually, higher prices, especially for food and energy, and lower equity values are likely to be a political constraint.

Rising risks to U.S. growth and inflation…

While the ultimate implementation remains uncertain, disruptive U.S. policy announcements have already damped U.S. consumer and business sentiment and will likely weigh on investment and hiring decisions (see Figure 2). Globally, if businesses face tariff-related risks that are close to impossible to calibrate, then the likely result is delayed decisions on investment and expansion. In other words, tariff uncertainty is proving to be a headwind to growth, even if tariffs fail to materialise.

We see a risk that U.S. growth and labor market momentum downshift more decisively. After U.S. real GDP grew 2.5% to 3% annually over the past few years, we expect a below-trend pace in 2025 and 2026.

The average effective tariff rate on U.S. imports has increased an estimated 7.5 percentage points from actions against Canada, Mexico, and China. We expect additional trade policy measures to raise that figure significantly throughout the year, as Europe and other southeast Asian countries could face U.S. tariffs.

Businesses are likely to pass on tariff costs, boosting inflation during the period of price adjustment and delaying the return to the Federal Reserve’s 2% target. More concerning for Fed officials, surveys of consumers and business suggest inflation expectations are moving higher.

In Congress, the focus is already on U.S. tax policy. Given the circuitous nature of the legislative process and the very narrow Republican majorities, especially in the House of Representatives, we do not expect to see a signed bill until summer, if not later. While we still expect trade, spending, and tax policies to have a neutral net effect on the U.S. fiscal impulse in 2025, a more significant near-term growth slowdown could tilt the scales toward larger, more stimulative tax cuts.

…While potential for fiscal stimulus and rate cuts helps the global outlook

Recent policy actions in other major economies appear to incrementally improve what were otherwise bleaker outlooks. Expectations for fiscal expansion are rising in countries such as China, Germany, Japan, and Canada.

China and Germany have strong incentives to implement structural changes. China’s housing overbuild and debt-deflation cycle contributed to an over reliance on exports – a model now strained by other countries’ unwillingness to import China’s production capacity. China appears more willing to implement policies to boost consumption while continuing to invest in technology and AI.

Germany is prioritising increased spending on defence and infrastructure after the pandemic, the war in Ukraine, and intense competition from China have upended the German economic model. Other European countries could follow suit but may have less capacity than Germany, which tends to run fiscal surpluses.

We expect growth trends to remain stable and mediocre outside of the U.S. Trade uncertainty remains a headwind, but easier financial conditions in more interest-rate-sensitive economies and fiscal loosening should provide some offsetting support.

Looser labor markets and an expected moderation in wage inflation should keep inflation outside of the U.S. on a declining path, allowing DM central banks to continue easing policy to neutral levels. We expect 50–100 basis points (bps) of additional rate cuts across DM economies over the rest of 2025. The Bank of Japan remains an outlier and is likely to raise rates in the face of elevated inflation expectations.

As a baseline, we expect the Fed to cut rates by another 50 bps later this year. The Fed is in a tricky spot, as higher inflation and lower growth risks have contrasting implications for the central bank’s price stability and full employment goals.

The main risk is that slowdowns in the labor market and real GDP growth cause the Fed to cut rates more deeply than the market is currently pricing, even if sticky inflation and rising inflation expectations delay the Fed’s reaction to early signs of an economic downturn. In the end, we expect Fed officials will cut more aggressively if they see recession risks rising faster than inflation expectations. In contrast, we believe the likelihood of the Fed reversing course and hiking rates in response to tariff-related inflation is low.

Investment implications: Seek simplicity, stability, and diversification

In this unusually uncertain macroeconomic environment, it’s prudent to prioritise simple, stable investments over trying to predict the unpredictable.

Elevated uncertainty is likely to challenge the U.S. equity outperformance of recent years. There is a strong case to diversify away from highly priced U.S. equities into a broader mix of global, high quality bonds. We believe we are in the early stages of a multiyear period in which fixed income can outperform equities while offering a more favourable risk-adjusted profile.

Historically, starting bond yields correlate very closely with five-year forward returns (see Figure 3). Yields on high quality bond portfolios are 4.65% based on the Bloomberg US Aggregate Index, and 4.80% based on the Global Aggregate Index (U.S. dollar hedged), as of 28 March 2025. Building on that baseline, active managers can identify opportunities in high quality sectors to seek alpha – returns above market benchmarks – to enhance the yields investors earn.

Meanwhile, the equity risk premium – a measure of the additional returns investors require to invest in riskier equities – turned negative in late 2024 for the first time in more than two decades, driven by historically elevated stock valuations coupled with the highest bond yields in years. It has since risen but remains near historical lows. (For more, see our February PIMCO Perspectives^[1].)

The portfolio diversification benefits of bonds have been on display in recent months. Equities and bonds typically move in opposite directions, allowing one part of a balanced portfolio to gain when another falters. As stocks have slumped, high quality bonds have thrived, delivering total returns comparable to equities over the past year while presenting favourable valuations today.

Duration looks more attractive

It remains unclear whether recent market volatility marks peak pessimism regarding U.S. policy uncertainty, or if the disruption will persist and further erode business and consumer confidence both in the U.S. and abroad, affecting economies and asset prices even more.

The rosy assumptions that buoyed risk asset pricing earlier this year have given way to a more cautious outlook. The decline in risk assets has accompanied a rally in U.S. Treasuries and Canadian government bonds, which contrasts with higher yields in Europe and the U.K. – in part the result of Germany’s planned fiscal spending increase.

Even after this year’s Treasury rally, the U.S. 10-year note yield remains firmly in the middle of our expected cyclical range of 3.75% – 4.75%. However, if recession risks rise, there is the potential for markets to price in more Fed rate cutting and for this range to shift down.

The German bond market experienced a sharp repricing in early March, reflecting changing political attitudes toward public spending. This shift is significant, given Germany’s unique position in the euro zone with its low debt levels.

Beyond Germany, we expect increased defense spending across Europe – though with measures likely to be less bold, given that countries with weaker initial fiscal conditions will struggle to fund such initiatives. Consequently, we have raised our expected range for the 10-year bund yield to 2.5%–3.5% from 2%–3%, indicating potential for further repricing.

Broadly, we favor an overweight to duration, a gauge of interest rate sensitivity. At a time of asymmetric risks across countries, we look to global diversification in high quality duration. We favor the U.K. and Australia for overweight duration positions. We view European duration as less attractive, given fiscal pressures, and expect yield curves to steepen across eurozone markets.

Rich global opportunities

The flip side of serial U.S. trade deficits has been the glut of foreign excess savings fueling U.S. capital markets. The world has been heavily weighted toward U.S. investments, particularly equities (see Figure 4), which now appear more vulnerable.

In this environment, we believe it makes sense to capitalize on global opportunities, particularly as bonds have become more attractive. In high quality duration, in credit, and in securities markets, we will look to emphasize the global opportunity set.

Emerging markets (EM) offer interesting alpha opportunities as well as diversification benefits. In high quality EM, historical default rates align with U.S. corporate credit, and premiums for structuring and illiquidity remain attractive. We see value in local currency opportunities that could benefit from capital flows being redirected from the U.S., as well as in hard dollar spreads where investment grade credit is increasingly available.

The risks to U.S. exceptionalism have reduced the attractiveness of the U.S. dollar. At the same time, tariff risks caution against short positions in the U.S. dollar, in case currency adjustment is the release valve should unexpected tariffs cause other currencies to depreciate. We favor carefully managed foreign exchange positions, to generate income outside of the U.S. while seeking to minimize correlations to the U.S. dollar or equity markets.

Favour asset-based finance over corporate credit

We are cautious on corporate credit, as we believe spreads fail to adequately account for potential downside risks.

While corporate bonds play an important role in portfolios, we currently see greater value in high quality alternatives. That includes credit derivative indices and an overweight position in agency mortgage-backed securities (MBS). We prefer high quality fixed income and securitised products.

In private credit, we believe asset-based finance (ABF) strategies offer the most favorable opportunities and entry points. We can identify attractive cash flow profiles that are typically fixed-rate, amortizing, and secured by tangible assets. This creates a narrower range of outcomes, making ABF a valuable addition to portfolios as other private credit assets face increased uncertainty.

This is especially true in corporate direct lending, where demand/supply imbalances (with more investor demand for loans than borrowers seeking solutions), weaker lender protections, and floating-rate coupons lead to a wider range of outcomes. We see competition in this space increasing, with significant investor dry powder chasing deals and banks returning to syndicated loan markets.

This is contributing to convergence in spreads between public and private leveraged credit markets. Contrary to expectations that the Trump administration would ignite merger and acquisition activity, heightened uncertainty has hindered M&A and slowed new deal flow.

Conclusion

With stock valuations and volatility unusually elevated, and credit spreads tight, high quality fixed income can offer attractive yields, stability, and a robust longer-term outlook for patient investors.

By Tiffany Wilding, managing director and economist and Andrew Balls, CIO Global Fixed Income.

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Global economic outlook and elevated equity valuations affect bond market yields and may benefit client portfolios.

Key takeaways

The change in U.S. leadership increases global economic uncertainty in 2025. The incoming administration’s protectionist proposals have the power to reshape trade relationships and alter economic dynamics worldwide. With actual policies and their impacts still uncertain, we foresee a wide range of potential outcomes. Here are our near-term economic views:

• Uncertainty is certain: Proposed U.S. policy pivots have broadened the spectrum of potential growth outcomes. Inflation risks in the U.S. and recession risks in many non-U.S. economies have both increased. Our baseline expectation is for economically manageable U.S. tariff increases on China and other trading partners. However, more forceful efforts to rectify longstanding trade imbalances could disrupt the global economy and financial markets. Across developed markets (DM), we expect inflation to continue converging toward target levels, enabling DM central banks to keep cutting interest rates. However, price level adjustments from higher tariffs could delay additional progress, especially in the U.S. Greater policy uncertainty amid a generally strong U.S. economy argues for a more gradual, data-dependent approach.

While the range of potential outcomes has widened in both directions – from brighter upsides to bleaker downsides – U.S. risk assets increasingly rely on optimistic scenarios. Buoyed by expectations of lower taxes and relaxed regulations, U.S. stocks have scaled new heights while credit spreads are near record lows. Although this momentum could continue, history indicates limited room for further sustained gains at current valuations. In contrast, bonds present an appealing opportunity in both the near term and over a longer horizon. Here are our investment views:

• Bonds are better positioned: Bonds are poised to play a crucial role in portfolios in 2025. We believe bond yields are attractive at a time when equity valuations and credit spreads are not, giving high quality fixed income a favourable starting point. Unlike cash, bonds stand to benefit from capital appreciation as policy rates fall, enhancing bonds’ role as a diversifier and stabiliser for equity exposure in portfolios.
• Use relative value as a guide: Exploring investments across diverse markets provides a broader perspective. Elevated U.S. deficits and divergent global economic paths enhance already appealing global diversification opportunities. Uncovering innovative, structural sources of return can also reduce reliance on directional bets related to economic growth or interest rates.

In this context, we see promising fixed income opportunities in the U.S. and other DM countries, particularly the U.K. and Australia, as well as in select emerging markets (EM). We also prefer agency mortgage-backed securities and asset-based investments over other credit sectors in both public and private markets.

Economic outlook: Uncertainty is certain

In our October 2024 Cyclical Outlook, “Securing the Soft Landing,” we said the U.S. economy, like others, appeared poised for a rare soft landing – moderating growth and inflation without recession. We said DM economies appeared on track to return to target inflation levels in 2025. We saw risks stemming from the U.S. election and persistently high sovereign debt levels.

The broad contours of that forecast remain in place. We expect global real GDP growth to slow modestly. Lower immigration and higher tariffs are likely to temper U.S. growth despite an otherwise robust economy. Meanwhile, Europe continues to lag with subpar economic performance.

China’s economic outlook remains precarious, with growth and inflation risks tilted downward due to still-cautious fiscal support, a deleveraging housing sector that has contributed to anemic private sector credit demand, high real interest rates, and excess manufacturing capacity. Despite a prolonged property sector downturn, China maintained a 5% growth target in 2024, bolstered by expanded manufacturing – particularly in semiconductors and technology – alongside infrastructure investment and export growth.

However, this growth model is faltering under the weight of escalating trade tensions, a sluggish consumer base, and longer-term declines in population and productivity growth. Central government officials are likely to lower the growth target to around 4.5% for 2025, with core inflation likely to remain subdued. This expectation already assumes a stimulus package of about 1.5 trillion Chinese yuan (1%–1.5% of GDP) will be necessary to bolster consumption in the year ahead.

The DM outlook for inflation gradually converging toward central bank targets remains intact, although higher U.S. tariffs could delay this process. Looser labor markets and declining inflation should allow DM central banks to keep cutting rates. We expect 50 to 150 basis points (bps) of DM central bank rate cuts in 2025, depending on the region.

The Bank of Japan (BOJ) remains the exception. We expect the BOJ to hike by 50 bps as higher inflation expectations support underlying inflation despite currency volatility.

Risks and potential outcomes

The U.S. election has expanded the range of potential economic outcomes. Our baseline scenario assumes economically manageable U.S. tariff hikes against China and other trading partners, while tax, spending, and trade policies leave net U.S. fiscal deficits unchanged around 6%–7% through 2025 and 2026 – an outcome with more limited economic implications.

However, the risk is that the incoming administration pursues more aggressive policy pivots (see Figure 1) to address persistent trade and fiscal deficits – policies that the administration argues will lead to more sustainable and equitable U.S. growth over time. Achieving meaningful changes in global trade imbalances would require altering global savings and investment patterns, reducing the consumption share of GDP in the U.S. and the manufacturing share elsewhere (e.g., China).

Without reforms in China or other trade surplus countries to cut implicit manufacturing subsidies and stimulate consumption, the U.S. could try to implement interventionist trade policies (e.g., a system of universal tariffs or foreign direct investment taxes) to compel these changes. However, distributing the burden of the U.S.’s global reserve status by making U.S. assets more expensive to hold would likely raise the cost of capital and – absent more aggressive fiscal deficit reduction – increase U.S. government borrowing costs.

Such aggressive short-term measures to reverse long-term trends would likely contribute to economic disruptions, near-term currency volatility, and U.S. equity market underperformance, even if they were to succeed at creating stronger, more balanced global growth longer term. Hence, President-elect Donald Trump’s tolerance for U.S. equity market volatility is a key question for the outlook.

These proposed policy pivots amplify both upside and downside risks to U.S. growth – especially as the exact combination, timing, and scope of any such policies remain unclear. However, we think the balance of potential policy outcomes increases near-term U.S. inflationary risks while posing greater downside risks to growth for non-U.S. countries, particularly those with high global trade exposure that run persistent surpluses with the U.S.

For example, any larger-than-expected U.S. government spending cuts, aggressive trade actions, or immigrant deportation could pose cyclical downside risks to both U.S. and global growth. Conversely, greater U.S. tax cuts and deregulation could enhance U.S. growth prospects, potentially aiding consumer and business confidence and risk asset performance. A focus on achieving fairer global trade, more efficient markets, and a sustainable U.S. debt trajectory could help maintain rising U.S. living standards. Thoughtful immigration overhauls that expand the productive labor force, streamlined regulations that encourage investment, and opening export markets for U.S. projects could also yield benefits for U.S. businesses and workers.

In the very near term, higher trade policy uncertainty could weigh on global industrial production, investment, and trade regardless of actual policy outcomes. While these isolationist, pro-U.S.-growth policies offer mixed risks for U.S. growth, they are generally more likely to be inflationary, especially since the U.S. economy is currently estimated to be operating at or near its potential.

The U.S. Federal Reserve (Fed) has taken note of these changing risks. In December, when the Fed cut its policy rate by 25 bps, officials revised projections to indicate fewer expected cuts in 2025 amid greater uncertainty around continued inflation progress. Fed Chair Jerome Powell said that some officials had factored potential Trump administration policies into their revised projections.

Although conventional wisdom suggests that central banks should look through one-off price level adjustments, such as those from tariffs, any tariffs that are accompanied by other pro-U.S.-growth policies could come with more persistent inflationary pressures. In various scenarios, Fed officials could remain concerned about the knock-on effects of rising inflation expectations and elevated wage growth. As a result, they could react by cutting less than previously expected, at least at first.

Thus, after 100 bps of policy rate reductions in 2024, the timing of further Fed cuts has become less certain, indicating a more gradual, data-driven approach in 2025. The futures market has reflected this uncertainty in recent months (see Figure 2). Despite the Fed cutting its policy rate by 100 bps during this period, market pricing removed the expectation of 100 bps of additional easing in the year ahead.

The long-term outlook for U.S. government debt is likely to remain a significant concern. Nevertheless, there is a possibility of some incremental deficit improvement with the potential for rollback of certain Biden administration policies – such as renewable energy investment credits and other elements of the 2022 Inflation Reduction Act – and cuts to Medicaid. Higher tariffs could also reduce deficits through increased government revenue collection.

Still, any meaningful deficit improvement will be difficult, with the expected extension of the Tax Cuts and Jobs Act – Trump’s first-term bill – and some additional tax cuts, including, for example, provisions to raise state and local tax (SALT) deduction caps. Although some spending reductions could be found through policies to improve government efficiency and reduce waste, any larger-scale cuts, including reforms to Social Security and Medicare programs, will require an act of Congress and likely be difficult to pass given the narrow Republican majorities, especially in the House of Representatives.

Investment implications: Bonds are better positioned

Financial markets seem to be pricing in a very positive baseline expectation – reflected in the strength of U.S. and other equity markets in recent months – at a time of elevated geopolitical uncertainty. Historically high equity valuations and U.S. deficits, along with the potential for escalating trade tensions, raise questions about the durability of stock market gains. Risks appear tilted to the downside, with little margin for safety. This environment presents a compelling case for taking some chips off the table.

We believe bond yields are increasingly attractive when measured against equity valuations and credit spreads. High quality fixed income starting yields – which are highly correlated with five-year forward returns – are 5.10% based on the Bloomberg US Aggregate Index, and 4.91% based on the Global Aggregate Index (U.S. dollar hedged), as of 10 January 2025. While continued equity gains would require valuations to be sustained well above long-term norms, bonds simply need historical trends to hold to generate attractive returns in line with starting yields.

Bond market returns can be further enhanced by capital gains in adverse macroeconomic or market scenarios. Historical trends also support bonds as an attractive risk hedge and portfolio diversifier (see Figure 3). Looking back at bond and equity markets on average since 1973, during similar periods when U.S. core bonds are yielding around 5% or greater while U.S. equities’ earnings ratios are around 30 or higher, bonds have offered higher five-year subsequent returns, and with potentially lower volatility (for more, see our December commentary, “From Cash to Bonds: A Strategic Shift in Post-Pandemic Investing^[1]”).

Rates and curve

Markets are pricing in terminal policy rates for global central bank easing cycles that appear somewhat high relative to our baseline outlook. There is significant near-term potential for lower central bank rates outside the U.S. in the event of more aggressive U.S. trade policies that weaken global growth and weigh on commodity prices (see Figure 4). In the U.S., even as elevated policy uncertainty could lead to a lengthier pause in the Fed’s cutting cycle, intermediate-maturity yields look attractive relative to our long-term 0%–1% neutral real interest rate baseline.

Given that, we expect to be overweight duration, a gauge of interest rate risk, particularly after the recent rise in yields.

Over our longer-term secular horizon, we still expect yield curves to gradually steepen, driven by central bank easing and a continuation of the recent rise in term premium amid concerns about elevated sovereign debt (for more, see our December PIMCO Perspectives, “Thoughts from the Bond Vigilantes”^[2]). However, we see scope for some cyclical flattening in the U.S. due to the possibility of delayed Fed cutting amid potential near-term inflationary pressures and marginal deficit improvement.

Balancing these secular and cyclical views, we are underweight the 30-year area of the U.S. yield curve and overweight in the five- to 10-year maturity range. U.S. Treasury Inflation-Protected Securities (TIPS) also remain a reasonably priced hedge against higher inflation outcomes, in our view.

Credit outlook

Corporate credit spreads are historically tight. While we expect corporate credit can continue to do fine in our baseline scenario, the range of outcomes appears skewed toward wider versus tighter spreads given the balance of global risks. Overall, we favor higher-quality bonds and maintaining liquidity.

We continue to prefer structured products, the investment grade credit default swap index (CDX), and high quality investment grade credit versus lower-quality investments. Given broadly tight credit conditions, we are shifting focus beyond global market-weight spread allocations toward high quality spread in harder-to-source areas. U.S. agency mortgage-backed securities (MBS) remain an attractively priced, high quality, and more liquid alternative to corporate credit.

Within private credit, we continue to prefer asset-based lending, especially assets tied to higher-quality DM consumers and residential mortgages. We also see value in many non-consumer forms of asset-based risk, emphasising sectors with secular tailwinds such as aviation and data infrastructure. We remain cautious on the existing stock of lower-quality, floating-rate debt outstanding, especially in corporate markets.

We have also observed a trend toward more aggressive financial engineering in some corporate credit areas. That is creating opportunities to use independent credit analysis to identify potential gaps involving perceived credit fundamentals and ratings.

Global views

While we see U.S. duration as attractive, at the same time upside and downside risks are more evenly balanced due to trade, fiscal, and regulatory policies. In the rest of the world, the balance of risks leans toward the downside. This environment supports global diversification across bond markets, particularly high quality duration. We favor the U.K. and Australia based on valuations and economic risks compared with the U.S. Tariffs can further bolster the case for global diversification, as many of the biggest disruptions are likely to occur outside the U.S.

EM local debt, external debt, and foreign exchange positions offer reasonable return potential and reduce reliance on U.S. credit, as these markets appear to price in more downside risk than do U.S. equities or corporate credit. We see foreign exchange carry strategies as an attractive and relatively liquid way to generate income from EM exposures, when combined with careful management of the currency basket to avoid excessive U.S. dollar correlation. At the same time, with the U.S. dollar likely to strengthen on tariffs, we favour long U.S. dollar positions versus the euro, Canadian dollar, and Chinese yuan, which can offer reasonable return potential in the baseline scenario and may offer protection against more adverse trade outcomes.

Structural tilts and active management

As the most accessible markets become increasingly expensive, sophisticated investors can unlock value through more structural strategies. The concept of structural alpha involves identifying repeatable structural inefficiencies in markets – e.g., decisions made by noneconomic investors such as central banks – and creating a diversified portfolio of these inefficiencies, reducing reliance on a directional macro view.

One example of structural inefficiency is home country bias, where investors feel more comfortable investing in their own country than elsewhere. We see this as a growing opportunity as capital markets continue to expand outside of the U.S.

Another example is the rise of passive exchange-traded funds (ETFs). Required daily data disclosure by ETFs has created an information advantage for active asset managers, who can track trading shifts in less liquid market areas. Also, as ETFs gain traction in mainstream sectors such as corporate credit, they enable larger trades. In recent years, synthetic indices of diversified credit instruments have become more liquid than the underlying bonds and have often outperformed those bonds due to technical factors, creating further opportunities to enhance returns.

Conclusions

Favourable global economic conditions, the capital preservation qualities of fixed income, and the potential for capital gains position bonds as a critical element of portfolios in 2025 and a source of diversification to complement exposure to riskier assets. Short-term volatility presents opportunity for active bond managers, while current yields and historical valuation trends suggest more predictable longer-term returns that are likely to be attractive compared with both cash and equities.

By Tiffany Wilding, managing director and economist and Andrew Balls, CIO Global Fixed Income. 

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References:
[1] https://www.pimco.com/gbl/en/insights/from-cash-to-bonds-a-strategic-shift-in-post-pandemic-investing
[2] https://www.pimco.com/gbl/en/insights/thoughts-from-the-bond-vigilantes

About our forums: PIMCO is a global leader in active fixed income with deep expertise across public and private markets. Our investment process is anchored by our Secular and Cyclical Economic Forums. Four times a year, our investment professionals from around the world gather to discuss and debate the state of the global markets and economy and identify the trends that we believe will have important investment implications. In these wide-reaching discussions, we apply behavioural science practices in an effort to maximize the interchange of ideas, challenge our assumptions, counter cognitive biases, and generate inclusive insights. At the Secular Forum, held annually, we focus on the outlook for the next five years, allowing us to position portfolios to benefit from structural changes and trends in the global economy. Because we believe diverse ideas produce better investment results, we invite distinguished guest speakers – Nobel laureate economists, policymakers, investors, and historians – who bring valuable, multidimensional perspectives to our discussions. We also welcome the active participation of the PIMCO Global Advisory Board, a team of world-renowned experts on economic and political issues. At the Cyclical Forum, held three times a year, we focus on the outlook for the next six to 12 months, analysing business cycle dynamics across major developed and emerging market economies with an eye toward identifying potential changes in monetary and fiscal policies, market risk premiums, and relative valuations that drive portfolio positioning.

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. References to Agency and non-agency mortgage-backed securities refer to mortgages issued in the United States. Structured products such as Collateralised Debt Obligations (CDOs), Constant Proportion Portfolio Insurance (CPPI), and Constant Proportion Debt Obligations (CPDOs) are complex instruments, typically involving a high degree of risk and intended for qualified investors only. Use of these instruments may involve derivative instruments that could lose more than the principal amount invested. The market value may also be affected by changes in economic, financial, and political environment (including, but not limited to spot and forward interest and exchange rates), maturity, market, and the credit quality of any issuer. Private credit involves an investment in non-publicly traded securities which may be subject to illiquidity risk.  Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy. The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. Diversification does not ensure against loss. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve. Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice. Correlation is a statistical measure of how two securities move in relation to each other. Duration is the measure of a bond’s price sensitivity to interest rates and is expressed in years. PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world.

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How does the current economic climate impact investor portfolios?

The fixed income outlook remains strong across multiple economic scenarios as the U.S. Federal Reserve joins other central banks in cutting interest rates.

Key takeaways

In the wake of pandemic shocks, economies appear more “normal” than at any time since 2019. Yet policy rates remain elevated. As central banks cut interest rates to more neutral levels, key questions include how fast they get there and what those neutral levels will look like. Here are our near-term economic views:

• The factors that supported relative U.S. economic strength are diminishing. That suggests some recoupling with the rest of the world and further progress on curbing inflation.
• Developed markets (DM) appear on track to return to target inflation levels in 2025, driven by normalizing consumer demand and increased competition for limited job openings. In the U.S., labor markets appear looser than in 2019, heightening the risk of rising unemployment. The Fed, like other DM central banks, is expected to realign monetary policy to this new cyclical reality.
• The U.S. economy, like others, appears poised to achieve a rare soft landing – moderating growth and inflation without recession. But there are risks, such as the upcoming U.S. election and its implications for tariffs, trade, fiscal policy, inflation, and economic growth. High budget deficits will likely persist, limiting the potential for further fiscal stimulus and adding to economic risks.

As developed economies slow and potential trade and geopolitical conflicts loom, investors should favor caution and flexibility in portfolio positioning. These are our near-term investment views:

• We expect yield curves to steepen as central banks lower short-term rates, creating a favorable environment for fixed income investments. Historically, high quality bonds tend to perform well during soft landings and even better in recessions. Moreover, bonds have recently resumed their traditional inverse relationship with equities, providing valuable diversification benefits.
• Bond yields are attractive in both nominal and inflation-adjusted terms, with the five-year area of the yield curve particularly appealing. Cash rates are set to decline alongside policy rates, while high government deficits may drive long-term bond yields higher over time.
• We maintain a cautious stance given some complacency we see in corporate credit due to tighter valuations, favoring higher-quality credit and structured products. Lower-quality, floating-rate private market areas appear more vulnerable to economic downturns and interest rate changes than prices suggest, with credit risks poised to rise just as yields fall, potentially benefiting borrowers but hurting investors. U.S. agency mortgage- backed securities (MBS) offer an attractive and liquid alternative to corporate credit. Additionally, asset-based sectors, in both consumer and non-consumer areas, provide appealing opportunities for private market investors, particularly relative to corporate lending.
• In foreign exchange, we are somewhat underweight the U.S. dollar as the Fed cuts rates, while diversifying into currencies from both DM and emerging markets (EM).

Economic outlook: Recoupling and a reframing of risks

The U.S. economy distinguished itself in 2023 and 2024, achieving growth rates of 2.5%–3%, while DM peers largely stagnated at 0%–1%. U.S. productivity has also outpaced DM peers since the pandemic. In our April 2024 Cyclical Outlook, “Diverging Markets, Diversified Portfolios,” we identified two main drivers:

• Fiscal policy: A larger cumulative fiscal stimulus since 2021 has led to greater private wealth accumulation in the U.S., which has taken longer to dissipate.
• Monetary policy: The pass-through of higher interest rates to households has been slower in the U.S., largely due to the existing stock of low-rate, long-term mortgages.

Additionally, the prominence of U.S. private credit markets has likely kept financial conditions more accommodative. An influx of investor capital in lower-quality corporate lending has intensified competition for deals while providing financing for weaker companies that may struggle to access other markets.

The U.S. has also been less affected by international spillovers from Chinese economic weakness. European countries, and Germany in particular, have been hurt by weaker trade with China and greater Chinese import competition. Financial gains and capital accumulation from generative artificial intelligence (AI) have also relatively benefited the U.S.

The U.S. also made more modest progress in 2024 than DM peers in reducing inflation. Core personal consumption expenditures (PCE) inflation, the Fed’s preferred gauge, is expected to finish this year near where it ended 2023, as tough base effects are likely to lift the reported year-over-year rate in the next several months.

In contrast, core inflation in other DMs has likely slowed by 1–1.5 percentage points during that period (see Figure 1). Europe achieved additional inflation progress as weak demand and corporate margin compression offset stillelevated unit labor cost inflation.

The factors that supported U.S. outperformance are fading, suggesting some recoupling with the global economy. Measures of U.S. real wealth balances more closely resemble those of other DMs. The monetary policy shocks that have impeded growth elsewhere are also abating.

European growth is likely to recover to a more normal pace as rates decline and trade conditions improve after the energy price spikes of 2022. This will help offset curtailed government spending and a weak global manufacturing environment. Immigration – which bolstered growth in many DMs, particularly the U.S. – is expected to become a growth headwind as policies implemented in mid-2024 to limit immigration appear to be working.

Despite some cyclical growth recoupling, we believe the U.S. economy maintains some distinct advantages. Notably, robust capital spending and AI investment trends present significant upside growth potential, especially compared with Germany and other EU countries that are more exposed to Chinese competition and more reliant on imported energy sources. Recent economic data revisions that have left the U.S. savings rate within prepandemic ranges should moderate concerns of an overextended U.S. consumer.

Monetary policy is normalising…

More resilient U.S. growth and inflation delayed the Federal Reserve in commencing its rate-cutting cycle relative to other central banks. However, forward-looking inflation indicators suggest that further progress toward the Fed’s 2% inflation target is likely in 2025. Factors supporting this outlook include unit labor cost inflation nearer to 2%, a vacancy-to-unemployed ratio lower than 2019 levels (see Figure 2), and a rising unemployment rate that may risk overshooting the Fed’s comfort zone of around 4.2%.

Elsewhere across DM, weaker demand, loosening labor markets, and anchored inflation expectations also point to near-target inflation in 2025. Canada stands out as a DM economy where inflation is most likely to undershoot target levels, while labor market indicators in Australia point to somewhat slower progress there.

Consequently, central banks, especially the Fed, are focused on returning monetary policy rates to estimated neutral levels. We expect DM central banks to cut rates by 175–225 basis points (bps) in 2025.

The Bank of Japan (BOJ), which still has a policy rate below neutral estimates, remains the notable outlier. We expect the BOJ to continue with gradual rate hikes despite recent market volatility and yen strength. Japan has been the one economy where elevated inflation has raised inflation expectations, while wage inflation remains firm.

…But what is normal?

With DM economic conditions now resembling their pre-pandemic baseline more than at any time since 2019, the focus now turns to the question, “What is ‘normal’ monetary policy?”

Factors that could support a somewhat higher neutral rate than a decade ago include higher government debt levels, potentially higher defense spending, generally stronger private sector balance sheets, and increased investment needs associated with secular global transformations, such as realigned trade relationships and the rapid development of AI.

However, given longer-term trends in demographics and wealth disparity, and the uncertain pace and magnitude of investment cycles, we’ve maintained our 0%–1% estimate for the long-run neutral real rate, as we detailed in our latest Secular Outlook, “Yield Advantage.” That suggests a neutral nominal policy rate in the range of 2%–3%. When we published that Secular Outlook in June, we noted how market pricing at the time implied that the neutral policy rate was unlikely to fall below 4%. Since then, market pricing has moved more in line with our expectations.

Given the uncertainty around the level of neutral policy rates, it’s natural for central banks to embark on a series of cuts to see how their economies respond. If growth reaccelerates and upside inflation risks reemerge, central banks can always pause or slow easing. Otherwise, if growth plummets or employment falters, there is capacity to cut more aggressively. Across a range of scenarios, we believe there is room for central banks to cut rates.

Risks and uncertainty

Risks to the global outlook have shifted. Inflation risks have diminished – but not disappeared – as supply/demand in labor markets and beyond have come into better balance. Growth is slowing. While DM economy recessions are not our base case, we believe the risks are somewhat elevated compared with historical average frequency. There are also scenarios where economic growth proves more resilient and inflation could reaccelerate.

In the U.S., the main risk is that slower activity and labor market growth fuel self-stoking cycles, ultimately resulting in a more pronounced downturn. Other DMs appear more stable. Still, their continued low growth makes them susceptible to negative shocks, such as market mishaps or escalating geopolitical situations.

China faces its own challenges. Its growth model, reliant on exports and manufacturing investment, seems to be hitting limits. It faces a significant housing inventory overhang, weak consumer demand, and rising trade tensions. In response, China’s government recently announced measures designed to boost asset prices and mitigate the decline in housing prices.

However, the efficacy of these policies may hinge on a return of confidence and whether the efforts will provide more widespread direct government support to households. Fiscal response is also likely and may help generate momentum for growth in the next one to two quarters.

We expect China’s growth to slow to 4%–4.5% in 2025 from 5% in 2023 and 2024, while the country continues to export deflation globally. Demand for commodities, especially related to construction, may get some support from the recently announced policies but isn’t likely to rise as much as in past cycles, given controls on new housing supply.

Geopolitical risks continue to loom large as a source of uncertainty – from the conflicts in the Middle East and Ukraine to elections across many countries during our cyclical horizon, with implications for broad market sentiment and specific countries and sectors.

The upcoming U.S. election is one such source of uncertainty, with pivotal policy implications:

• U.S. deficits will be the biggest loser no matter which party wins. Tax reform will dominate Washington next year, when the individual provisions of the 2017 Tax Cuts and Jobs Act are set to expire. We do not expect much additional fiscal stimulus, given likely narrow majorities or a divided government and lack of fiscal space. However, fiscal consolidation isn’t expected either. Annual deficits are likely to remain high (6%–7% of GDP) before any additional policy changes, due to lack of political will to curb entitlement spending as well as few offsets to pay for extending most of the 2017 tax cuts. This reinforces our curve steepening view in the U.S.
• The direction of travel of tariffs is also clear regardless of who wins. However, the potential for globally disruptive trade policies appears greater under a second term for former President Donald Trump, while Vice President Kamala Harris seems more likely to continue the current more targeted approach should she prevail. In the short run, higher tariffs would likely be inflationary and drag on growth. Tariffs could make tangible U.S. investments more expensive, hurt U.S. export sectors by making them less competitive, and weigh on demand. Tariffs would likely also be inflationary for close U.S. trade partners – to the extent that their governments retaliate with similar trade barriers – but deflationary elsewhere, as slower global growth from rising trade uncertainty could weigh on commodities, while goods previously supplied to U.S. markets could be redirected. The relative implications of tariffs will create a tough economic environment for the Fed. Monetary policymakers will have to be mindful that higher short-run inflation (as the additional costs of tariffs are passed on to consumers) risks rising inflation expectations, despite the downside risks to growth as real incomes fall.

Investment implications: Favourable conditions for high quality bonds

Uncertainty, global dispersion, and potential volatility create a favorable environment for active fixed income investors, especially as falling interest rates provide a tailwind for bonds. Historically, bonds tend to perform well during soft landings and even better in harder landing scenarios. Recently, bonds have resumed their traditional inverse relationship with equities, offering diversification and hedging benefits for portfolios. Additionally, bonds appear inexpensive compared with other assets such as stocks, in our view.

We expect yield curves to continue to steepen – in line with their performance in past easing cycles – as the Fed and other central banks continue cutting short-term rates. While recession is not our baseline, economic risks remain a source of uncertainty as U.S. growth slows. The risks are compounded by uncertainties around the upcoming U.S. election, particularly the outlook for global trade. This context calls for a careful approach to position sizing and maintaining flexibility in portfolios.

Rates and curve

We see U.S. Treasury yields as broadly fair at current levels. The five-year area of the yield curve appears particularly attractive in both the U.S. and other DM countries. As central banks lower policy rates, it creates reinvestment risk for cash and other short-term instruments. We prefer locking in attractive yields on intermediateduration bonds, which can benefit from price appreciation and historically have tended to perform well during rate cutting cycles. Meanwhile, we remain cautious on long-duration bonds as high government deficits could push long-term yields higher over time.

The anticipated pace of Fed easing priced into the front end of the curve appears reasonable, given current economic conditions and the Fed’s half-point initial cut in September. Expectations for the terminal rate also look reasonable given our baseline view on the long-run neutral rate (0%–1%), as discussed above, although we remain mindful of potential inflationary tail risks. If a recession hits, there is room for terminal rates to drop significantly.

Bond and equity markets have resumed their traditional inverse relationship – meaning the correlation between duration (a gauge of interest rate risk) and equities is negative – so bonds can better hedge portfolios against equity market downturns. That can be especially important at a time of rising geopolitical risks. Adding to an allocation of inflation-linked bonds is appealing, given attractive pricing for inflation protection, with yields attractive on both a real (inflation-adjusted) and nominal basis.

Credit outlook

We maintain a cautious stance on corporate credit due to tighter valuations and somewhat elevated recession risks. We prefer higher-quality credit and structured products over lower-quality credit at this point in the cycle, with an emphasis on liquidity, flexibility, and robust positioning against potential macroeconomic downturns.

Generally, we favor high quality investment grade credit. We set a high bar for considering lower credit quality, especially in portfolios with high quality benchmarks. Elsewhere in credit markets, we’re wary of deteriorating covenant protections in leveraged credits, which could lead to lower recoveries during idiosyncratic or systemic shocks.

Agency mortgage-backed securities (MBS) appear attractively valued and provide a reasonably priced, liquid alternative to corporate credit for investors who can tolerate occasional short-term volatility.

In private credit markets, we believe that excessive growth and complacency are likely to result in weaker future returns when compared with current yield levels. Significant capital formation has resulted in weaker lender protections and compressed compensation for illiquidity relative to similar returns available to active managers in public credit markets.

We believe many lower-quality, floating-rate borrowers in private markets are more susceptible to economic weakness and interest rate changes than market prices suggest. As the Fed lowers rates to prevent a recession, floating-rate coupons will likely also decrease significantly. This means yields will drop just as economic and credit risks rise, which may benefit borrowers but hurt investors. This could also be the first time these markets are tested during economic downturn scenarios.

Given this backdrop, investors today may be receiving inadequate compensation for risk in lower-quality private corporate credit – especially compared with attractive excess return opportunities in more liquid forms of credit or 2 similarly less liquid opportunities in asset-based lending. (For more, see our 10 July 2024 publication, “Navigating Public and Private Credit Markets: Liquidity, Risk, and Return Potential”).

Disruption to bank business models is creating attractive entry points for private capital across a range of asset-based opportunities, including consumer-related (e.g., residential mortgages, student loans) and non-consumer (e.g., aviation, equipment) assets. Relative to private corporate markets, we find many asset-based opportunities benefit from a combination of attractive starting valuations and favorable fundamentals, especially in areas tied to the higher-quality consumer balance sheet. These markets are also less crowded on a relative basis, as capital formation in private asset-based lending remains considerably more scarce than that of U.S. and European corporate lending markets.

We believe we are closer to a bottom in private real estate markets, but that this will be a slower recovery relative to previous cycles. We favor investments in data infrastructure and debt-related opportunities relative to equity at current valuations. Our emphasis is on sectors and assets tied to data infrastructure, logistics, warehouses, and certain multifamily assets.

Global views

Given dispersion in economic outlooks and central bank policy paths, we favor duration positions in the U.K. and Australia, where terminal pricing for the central bank cycles (see Figure 3) still looks somewhat high versus the U.S., the eurozone, and other global markets.

In the eurozone, the market’s terminal rate pricing for the European Central Bank looks reasonable, but there is some uncertainty on the timing of how quickly the easing cycle proceeds. Overall, we are neutral on duration but favor curve steepening positions given the flatness of the curve between the 10- and 30-year points.

Looking at foreign exchange (FX), we prefer an underweight position in the U.S. dollar, given risk of weakening as the Fed lowers rates, while diversifying with EM and DM positions. Careful scaling of positions is needed here, however, given the uncertainties surrounding the U.S. election.

A stable-to-weaker U.S. dollar amid rate-cutting cycles across DM should enable EM central banks to cut rates as well. While the Fed was on hold, many of these central banks had to keep rates higher than their benign domestic inflation would normally require.

We prefer investments in markets with steep yield curves and stable or improving political conditions, such as South Africa and Peru. Turkey also remains of interest given the ongoing pivot to greater economic orthodoxy. The favorable global environment we expect should remain supportive of EM external debt spreads.

Certain commodities can help diversify portfolios and provide hedging properties against inflation risks. The shifting global landscape continues to support gold and precious metals, with EM central banks purchasing gold at unprecedented rates since Russia’s invasion of Ukraine. Meanwhile, the desire of OPEC+ to return supply to the market and concerns over global transport demand have limited the upside to oil prices, even as recent events in the Middle East and Ukraine underscore the fragility of global supply chains. The capital spending cycle linked to the energy transition also supports prices of base metals, although lingering downside risks to growth in China pose challenges.

By Tiffany Wilding, managing director and economist and Andrew Balls, CIO Global Fixed Income. 

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References:
[1] Liquidity refers to normal market conditions.
[2] Ibid.

About our forums
PIMCO is a global leader in active fixed income with deep expertise across public and private markets. Our investment process is anchored by our Secular and Cyclical Economic Forums. Four times a year, our investment professionals from around the world gather to discuss and debate the state of the global markets and economy and identify the trends that we believe will have important investment implications. In these wide-reaching discussions, we apply behavioral science practices in an effort to maximize the interchange of ideas, challenge our assumptions, counter cognitive biases, and generate inclusive insights. At the Secular Forum, held annually, we focus on the outlook for the next five years, allowing us to position portfolios to benefit from structural changes and trends in the global economy. Because we believe diverse ideas produce better investment results, we invite distinguished guest speakers – Nobel laureate economists, policymakers, investors, and historians – who bring valuable, multidimensional perspectives to our discussions. We also welcome the active participation of the PIMCO Global Advisory Board, a team of world-renowned experts on economic and political issues. At the Cyclical Forum, held three times a year, we focus on the outlook for the next six to 12 months, analyzing business cycle dynamics across major developed and emerging market economies with an eye toward identifying potential changes in monetary and fiscal policies, market risk premiums, and relative valuations that drive portfolio positioning.

Past performance is not a guarantee or a reliable indicator of future results.  All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. 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