The election results represent a resounding win for Takaichi, with the LDP alone winning a two-thirds supermajority in the Lower House. Together with their coalition partner, the Japan Innovation Party (JIP), Takaichi now effectively controls 76% of Lower House seats. While the LDP does not have a majority in both houses, the Lower House supermajority enables the LDP/JIP coalition to override any opposition from the Upper House.

Takaichi secured the election by pledging decisive leadership and a vision for a more self-sufficient and assertive Japan, while also addressing the country’s cost of living crisis. Opinion polls consistently indicate that inflation is the most pressing concern among voters. With the electoral mandate, Takaichi will be able to press ahead with planned reductions in consumption taxes, expand household subsidies, and implement strategic investments and reforms in sectors such as semiconductors, shipbuilding, and AI. Additionally, increased defense spending looks likely. All in all, fiscal spending may increase by 2%–3% of GDP.

While fiscal stimulus may boost near-term growth, which has helped Japanese equities outperform global equities by 6 percentage points this year, increased government spending comes with its own risks. Notably, Japanese bond and currency markets were initially spooked in mid-January following the announcement of the snap election, reflecting concerns about debt burdens, political pressure on the Bank of Japan (BOJ), and the prospect of higher inflation.

Fiscal crisis concerns, while relevant, are overblown. Japan’s debt-to-GDP ratio has been declining in recent years, and interest expense as a percentage of GDP is lower than in other developed countries. Additionally, foreign ownership of JGBs is relatively low, reducing the likelihood of a sudden fiscal crisis or a “Liz Truss moment” similar to what the United Kingdom experienced in 2022. The recent rise in Japanese bond yields has been driven by rising inflation in Japan and reduced bond purchases by the BOJ, which has sought to shrink its balance sheet. With core inflation running close to 3%, real interest rates in Japan are still low, which is partly why the yen remains under pressure.

Tackling cost of living concerns ultimately requires a stronger yen, as a weak yen is partly to blame for inflation pressures. The Japanese government has made it clear that it will intervene if the USD/JPY exchange rate approaches the 160 level. But such a level will be hard to defend in the absence of higher interest rates. Given the election all but guarantees increased fiscal stimulus, the BOJ will need to continue hiking rates, otherwise, it risks a further rise in inflation.

Continued BOJ rate hikes, combined with modest rate cuts by the Federal Reserve, would further narrow the yield gap between Japan and the United States, providing support for the yen. Additionally, higher government bond yields in Japan could prompt the repatriation of some Japanese overseas bond holdings, exerting further upward pressure on the yen.

Overall, we see the election outcome as positive for the Japanese economy and, by extension, the yen. To capitalize on this outlook, we favor strategies that are less sensitive to JPY appreciation. Specifically, we like Japanese small-cap equities, which are a significant component of our current tactical recommendation to overweight developed markets small caps, as well as private equity buyouts and activist strategies. These strategies are well-positioned to benefit from stronger domestic growth and the ongoing momentum in corporate governance reforms and merger & acquisition activity within Japan’s market.

The post Japanese Election Result Should Boost the Economy and Ultimately the Japanese Yen appeared first on Cambridge Associates.

by TJ Scavone

Yields on most major developed market (DM) sovereign bonds reached a multi-year high in 2023 and have since held just below those highs, trading in a relatively narrow range. We expect this pattern to persist into 2026, supported by a resilient yet uncertain economic and policy backdrop, fair valuations in most markets, and ongoing yield curve pressures. Investors should keep allocations to high-quality sovereigns closely aligned with policy guidelines.

Looking ahead to 2026, the environment for most high-quality sovereigns remains broadly supportive. Economic growth is healthy but slowing—DM real GDP is projected to rise 1.7% in 2025, down from 1.9% in 2024, with most of the deceleration in the United States. While US consumer spending remains supportive, the labor market has softened, and the full impact of tariffs remains uncertain. These dynamics are likely to keep the Fed and other major central banks biased toward modestly easing in 2026, despite persistent inflation concerns. Overall, softer labor markets, tariff headwinds, and resilient but softer growth—supported by healthy consumer spending, AI capex, and easier policy—should limit both recession and inflation risks, resulting in modestly lower policy rates in many markets and rangebound sovereign bond yields in 2026.

Given this backdrop, we recommend maintaining exposure to high-quality sovereign bonds, with duration risk kept in line with benchmarks. The case for a short-duration stance has weakened as short-term rates have declined and yield curves have steepened, raising the opportunity cost of holding cash. Likewise, the case for adopting a long-duration stance is not compelling. Long duration typically outperforms when growth slows and central banks ease, but we anticipate only limited monetary easing. The European Central Bank and Bank of England have already delivered most of their anticipated cuts and markets are pricing in around 75 basis points (bps) of Fed cuts in 2026—a scenario that looks optimistic, considering current risks. Additionally, sovereign bond yields in key markets, like the United States and euro area, are currently in the bottom half of what we consider their fair value ranges, leaving little room for further declines absent a recession.

There are risk factors that warrant close attention. We have recently seen longer-duration sovereigns underperform as a range of influences—including fiscal concerns, elevated macro volatility, and cyclical factors—have put upward pressure on yields further out the curve. Fiscal pressures in particular have repeatedly made headlines in recent years, with many DM countries facing challenging fiscal outlooks and heightened volatility around budget stand-offs. While fiscal pressures warrant monitoring, market pricing does not signal imminent fiscal crisis, nor are they the sole driver. Elevated macro volatility, structural headwinds, and cyclical factors like monetary policy have also contributed. Many of these influences should reverse in a growth shock, allowing bonds to rally and provide portfolio ballast, as seen at points this cycle. However, with these crosscurrents, investors should demand more attractive yields before adding exposure. For context, yields would need to rise another 130 bps–180 bps to reach the upper end of their implied fair value range in the United States and Germany. Some regions offer more value, but domestic and currency risks need to be considered. In most cases, we recommend waiting for more attractive US Treasury valuations—given global spillover effects—before extending duration risk.

Overall, we anticipate that bonds will outperform cash in most major markets—supported by steeper yield curves—and should maintain their defense role in a downturn. However, since current bond yields are not especially attractive relative to our fair value estimates, we recommend maintaining allocations at policy levels, and keeping duration risk closely aligned to benchmarks.

Investors should underweight public corporate credit in 2026

by TJ Scavone

At present, the public credit universe offers few compelling opportunities. While returns have been solid and fundamentals remain sound, public credit is increasingly a one-sided trade. Spreads for both investment-grade and high-yield corporates are near historic lows, and the economic backdrop is turning less supportive. We see potential for spreads to widen in 2026 and beyond, and as a result, we favor higher-quality spread products that offer better relative value and more diversified return streams.

US investment-grade corporate bonds returned 6% annualized over the trailing three years as of November 30, and US high-yield bonds returned 10%. These strong returns were driven by high starting yields and a significant narrowing in credit spreads—down 52 bps for investment-grade and 179 bps for high-yield. The tightening in spreads, a pattern that was evidenced across most regions and instruments, was justified by robust economic and earnings growth, resilient corporate fundamentals, and subdued issuance, but yields are now less compelling, and spreads are historically tight across public credit.

While spreads could drift lower in the near term, upside for public credit is limited and downside risks have increased. The environment is more fragile, with slowing growth and emerging stress in the labor market and among low-income consumers and select corporate borrowers, highlighted by recent high-profile defaults. Riskier assets look increasingly vulnerable after the sharp run-up in equity valuations, as discussed earlier in this outlook, and the potential for slower growth and elevated costs could pressure corporate earnings and margins. Although material spread widening is not our base case, the credit cycle is maturing and risks favor wider spreads, supporting an underweight stance in public corporate credit within core fixed income.

Despite expensive public credit markets, select spread products offer compelling relative value. We favor US agency mortgage-backed securities (MBS)—particularly higher-yielding current coupons—and US municipal bonds (munis). We believe current coupon MBS are higher quality and well positioned to outperform if spreads widen, providing defense without sacrificing yield. Notably, current coupons (4.9%) now yield more than corporates (4.8%). Historically, at these levels, current coupons have outperformed corporates 62% of the time over the next two years, with returns ranging from -3% to 11% per year. Their spreads, unlike corporates, remain above historical lows with room to tighten as rate volatility subsides. Although rate volatility has declined since its recent peak, it remains somewhat elevated. With quantitative tightening ending and further modest rate cuts likely once tariff-related inflation pressures ease, there is scope for both volatility and MBS spreads to compress further, supporting returns.

Munis also offer attractive relative yields for taxable investors. For high-tax-bracket US families, munis have consistently delivered stronger after-tax returns than Treasury bonds and corporates. After adjusting for taxes, the yield advantage for munis is unusually wide—currently about 185 bps versus Treasury bonds and 93 bps versus corporates, among the widest taxable-equivalent spreads since the Global Financial Crisis, excluding isolated stress periods. Many taxable investors reduced muni holdings over the past decade, favoring Treasury bonds or, in some cases, even reaching for yield in credit, as low yields limited their tax advantage and valuations were less compelling. That is no longer the case, and the current environment favors shifting back toward munis at the margin.

Against this backdrop, it is important to recognize that public credit markets overall offer limited upside and heightened downside risk as spreads remain tight and the economic outlook softens. In this environment, we recommend a defensive posture within core fixed income, emphasizing higher-quality, more resilient sectors, with attractive relative value. US current coupon agency MBS and municipal bonds stand out for their relative yield advantage and diversification benefits. For those investors for whom these investments are appropriate, focusing on them may help position portfolios for more balanced risk-adjusted returns in 2026.

Investors should lean into private asset-based finance strategies in 2026

by Wade O’Brien

In 2026, credit investors face challenges such as expensive valuations, moderating growth and falling yields. Recent bankruptcies like First Brands and Tricolor also highlight the risk of weaker underwriting in at least some segments. We believe the solution is focusing on less correlated private credit strategies such as asset-based finance (ABF), insurance-linked securities, and litigation funding. Some of these strategies can be accessed via semi-liquid vehicles, freeing up illiquidity budgets for other parts of the portfolio.

Less correlated private credit strategies are attractive relative to expensive public credit assets. Strong demand has pushed spreads on assets like US high-yield and investment-grade bonds near the bottom decile of historical data, as we discuss elsewhere in this outlook. While demand across products is likely to be underpinned by yields near historical medians, returns are vulnerable if the pace of expected Fed cuts disappoints.

ABF funds offer investors the ability to diversify portfolios away from cyclical and expensive corporate lending. These funds lend against a variety of assets including consumer loans, real estate, and equipment leases. Underlying loans are less economically sensitive and have shorter maturities, allowing lenders to reprice them more quickly as conditions change. Accelerated cash return can also help investors concerned about slower distributions in other parts of their private portfolios. Recent bankruptcies have drawn attention to the ABF market, but were idiosyncratic, given the fraud and business practices involved. Still, they highlight the importance of careful manager selection, as both cases involved red flags that were ignored by markets. Fundraising by dedicated ABF funds has picked up but remains a fraction of the volumes seen in other private credit strategies.

While direct lending funds are currently less attractive in our view than less correlated private credit strategies, they remain attractive relative to comparable public credits. Fed rate cuts and lower spreads will impact returns, but fundamentals have been stable and defaults limited. The biggest near-term challenge for direct lending funds is competition from both the syndicated loan market and retail-targeted vehicles. Semi-liquid retail funds, including private business development corporations (BDCs) and interval funds, had accrued around $350 billion in assets by year-end 2024, a 60% increase in just two years. Reduced buyout volumes have cut supply and added to pressure on spreads, but resurgent M&A activity as rates decline and tariff uncertainty clears may help. Lower middle market lending funds, which offer higher spreads and better protections for lenders, are preferred to upper middle market.

Investors can access direct lending and ABF via open-ended vehicles as well as traditional closed-end funds. Private BDCs and interval funds may charge higher fees but offer investors the ability to more frequently adjust exposures. Investors that can access lower fee institutional evergreen funds may find them an attractive substitute for liquid credit assets featuring low spreads and yields.

Other private credit strategies—such as royalties, litigation finance, and insurance-linked securities—also have appeal. They tend to have resilient income streams insulated from the economic cycle and less sensitive to corporate fundamentals. Returns for these strategies have compared favorably with other types of private credit in recent years. These markets require highly specialized expertise, making their return streams less vulnerable to rising competition or surging demand from retail-targeted offerings.

In summary, with public credit markets offering limited value and increased competition, investors should look to private credit—especially ABF and specialized strategies—for better diversification, resilience, and risk-adjusted returns in 2026.

The post 2026 Outlook: Fixed Income Views appeared first on Cambridge Associates.

The case of the United States

To begin, we focus on the United States, the largest market globally with significant global spillovers. The US yield curve has been steepening for some time, having bottomed out midway through 2023. Since then, most of the steepening has occurred between the two-year and ten-year segments, but in 2025, the more notable steepening has taken place between the ten-year and 30-year parts of the curve (Figure 1). To put these moves in perspective, it is useful to examine how these yield curve segments have behaved historically.

Historically, both portions of the yield curve have tended to follow a somewhat consistent path during monetary policy cycles, steepening into and during rate cutting cycles before flattening as the expansion matures. In the current cycle, the yield curve’s behaviour has been broadly consistent with past episodes (Figure 2). The ten-year/two-year curve remains at untroubling levels and is not indicative of fiscal stress. From the perspective of those who harbour fiscal concerns, the 30-year/ten-year segment has arguably steepened a little more than is typical at this stage of the cutting cycle, and at a slightly speedier rate than during the COVID-19 cycle. Still, the speed of the recent steepening is more in line with the two prior cycles.

Much of the recent concern about long-dated bonds stems from the fact that, until last month, the 30-year yield had not been very responsive to increased easing priced in at the short end, especially compared to the last cutting cycle. However, the previous cycle was unique: the economic deterioration caused by the COVID-19 pandemic was atypical, with an almost complete hiatus in economic activity and significant uncertainty about normalisation. As a result, 30-year yields declined much more in sympathy with short yields during the steep portion of the rate cutting cycle, aided by quantitative easing (QE). Historically, though, it is normal for 30-year yields to react little as cuts are priced in during more typical cycles, since many economic cycles will occur over a 30-year bond’s life, reducing sensitivity to any single cycle (Figure 3).

Drivers of recent 30-year performance

To the extent that there has been some moderate excess underperformance at the 30-year point, what explains it? One hypothesis is that inflation expectations are rising in response to recent economic or political developments. Tariffs are indeed putting some upward pressure on US inflation. The probability that Federal Reserve independence could be undermined appears to be rising, potentially leading to unjustified easing and higher future inflation. A final supposition – itself related to debt load concerns – is that central banks may target higher inflation rates over time, whether implicitly or explicitly, to reduce debt burdens in real terms (Figure 4).

All these conjectures are plausible, but recent market action does not support them. Thirty-year breakeven inflation rates have traded in a band between 2.1% and 2.5% for the past three years. At a current level of 2.21%, they are firmly in line with their historical median. Instead, the recent rise in long-dated yields has been driven by a rise in real rates.

Relative supply/demand dynamics have played a significant role. On the supply side, it is politically difficult for governments to engage in meaningful fiscal consolidation. Indeed, the inability to do so has led to the fall of four governments in France in just over a year. As a result of this dynamic, expectations for more consistently elevated budget deficits and greater government bond supply have grown in recent quarters. In the United States, for instance, the International Monetary Fund (IMF) expects the fiscal deficit to remain at or above 5.5% through 2030.

On the demand side, buyers of long-dated bonds typically differ from those of shorter-dated debt, with pension funds and insurers being notable examples. Regulatory reforms in these industries have significantly influenced long-dated bond performance. Japanese insurers, for example, had been increasing their holdings of long-term Japanese government bonds (JGBs) to meet new solvency requirements. However, after meeting those targets, they have recently become net sellers, contributing to record-high 30-year JGB yields (Figure 5). In the Netherlands, the €1.5 trillion Dutch pension industry is transitioning from a defined benefit to a defined contribution system, leading to asset allocation changes and the sale of, according to Rabobank estimates, about €127 billion in long-dated sovereign debt to increase allocations to higher-returning assets. In the United Kingdom, defined benefit pension schemes’ aggregate funded status has been in surplus long enough that de-risking (increasing allocations to long-dated debt to match liabilities) has decelerated. While these developments are most impactful domestically, they have global spillover effects.

A final factor is that central banks are no longer price-insensitive buyers of government debt. Through QE, they built up large portfolios of domestic government debt to improve monetary policy transmission when policy rates were low. Once further easing was no longer required, they shifted to rolling over maturing debt. More recently, central banks have been shrinking their balance sheets. In the United States, up to $5 billion worth of Treasurys roll off the balance sheet each month. The Eurozone, Japan, and the United Kingdom, have been more aggressive: the Eurozone allows a greater proportion of debt to roll off, while the Bank of Japan and the Bank of England (BOE) have been actively selling down their portfolios.

Lower liquidity at the long end of the curve means these policy decisions have likely had a disproportionate impact on long-dated yields, especially given simultaneous demand-side changes. However, these policies are not set in stone, and policymakers can adjust both the quantity and distribution of bond sales and reinvestments in response to market conditions ¹ .

Focus on the United Kingdom

Rising long-dated bond yields are an international phenomenon, not one confined to the United States. Long yields are rising and yield curves are steepening in all major bond markets. However, discussions of potential fiscal crises have focused most prominently on the United Kingdom. Superficially, this is understandable: the 30-year yield in the United Kingdom recently reached levels not seen since the late 1990s, and the UK 30-year yield spread versus the United States has also been rising (Figure 6). However, this overlooks the diverging path of short rates in both markets. Normalising for this by looking at the relative shape of the yield curves shows that the UK yield curve is in the middle of its range relative to the United States for the past 3.5 years. UK two-year yields have been stable to marginally declining in recent months, rather than spiking as they did after the September 2022 budget.

This suggests the United Kingdom is not in an acute market funding crisis, further evidenced by the recent ten-year gilt syndication being ten times oversubscribed and the resilience of sterling during these moves. This is less surprising when considering that UK government debt, while elevated at around 100% of GDP, is below all G7 peers except Germany. By 2030, the UK budget deficit is forecast to be lower than all G7 nations except Canada, according to IMF projections. While there is risk of fiscal slippage, this applies to most peers. Year-to-date GDP growth in the United Kingdom has also outstripped all G7 peers.

Despite these relatively positive metrics, the United Kingdom faces issues that cast a shadow on debt sustainability, foremost among them are supply-side constraints. Strong relative growth notwithstanding, potential growth is being crimped by underinvestment (especially post-Brexit), labour market rigidities (post-Brexit and aggravated by COVID-19), and elevated housing and energy costs. Progress on these supply-side issues would have a twofold payoff: boosting growth (improving debt sustainability via both lower deficits and a higher GDP denominator) and lowering inflation, which is currently sticky due to these bottlenecks. This would allow the BOE to cut rates more aggressively, reducing gilt interest rates.

Holding two fiscal events each year draws unnecessary focus to UK fiscal issues, which are not necessarily worse than peers on many metrics. The memory of the September 2022 budget debacle also plays a role. Negative perception is aggravated by the fiscal juggling act required to meet self-imposed fiscal rules, resulting in policy uncertainty and constraining the ability to draw up a compelling growth plan. Perception of stability is important for a current account deficit country like the United Kingdom, which relies on foreign capital inflows. All told, the United Kingdom is not in a debt crisis, and the flexibility of the BOE and Debt Management Office to moderate the size and distribution of bond sales should help smooth over any demand indigestion for long-dated bonds. Nonetheless, the upcoming Autumn Budget could engender fresh rate volatility, and markets will look for a credible deficit reduction plan.

Conclusion

Rising issuance, elevated debt levels, and cyclically rising interest rate burdens have understandably brought debt sustainability to the forefront of market participants’ minds. However, any even moderately disorderly moves in yields have been restricted to the very long end of the yield curve, not further down at the ten-year point, for instance. This suggests the drivers are more idiosyncratic to the long end, rather than a generalised debt-sustainability trade. The fact that the 30-year performance has not discriminated against Germany further indicates that imminent fiscal fears are not the primary driver. Though Bund issuance will increase in coming years, German debt sustainability is not in question in the manner of other markets.

While markets are not being driven by fiscal crisis fears, secular shifts are occurring in bond markets. We have moved from a period of consistently negative term premium (the extra return demanded to hold a long-term bond rather than rolling short-term bonds) to the return of positive term premium (Figure 7). This likely reflects a combination of factors: diminished deflationary tail risks, a more volatile inflationary profile, shifts in the supply/demand balance (increased issuance versus quantitative tightening and demographic shifts), and increased political and geopolitical volatility. These trends may prove durable. It is also possible that neutral interest rates will rise should AI deliver the productivity gains its proponents suggest. These secular changes could eventually aggravate debt load concerns in developed markets, given their already unsustainable trajectory.

While investors should remain vigilant regarding debt sustainability, markets are not beginning to price in a fiscal crisis in our view. Furthermore, given how well telegraphed many of the risk factors listed above have been for some time, it would be premature, we think, to forecast that such a crisis will unfold imminently. Indeed, this month and last, bonds across the yield curve have shown they retain the propensity to rally on the back of slowing macroeconomic data. This quality remains highly valued and underpins our conviction that high-quality fixed income should continue to play a core role in portfolios. At present, with valuations broadly in a fair-value range, we recommend maintaining a neutral duration stance and waiting for yields to become more attractive relative to fundamentals before considering an extension of duration.

Mark Sintetos also contributed to this publication.

Footnotes

1. Bank of England, “Asset Purchase Facility: Gilt Sales – Market Notice 18 September 2025,” Bank of England, 18 September 2025.

The post Long Bond Performance Does Not Signify an Impending Debt Crisis appeared first on Cambridge Associates.

The Fed is weighing whether to lower its policy rate from 4.25%–4.50% at its September meeting, which would mark the first cut since December. After reducing rates by 100 bps in the second half of 2024, the Fed paused to assess the impact, as robust growth, a strong labor market, and sticky inflation limited the case for further cuts. In 2025, US growth has slowed—real GDP rose 1.4% in the first half versus 2.5% in 2024—while core CPI remained elevated at 3.1% in August and higher tariffs threaten to add to inflation. In July, the Fed held rates steady, citing inflation risks. However, newly revised data revealed a much softer labor market—the three-month average pace of job growth fell to 29,000 in August, down from 209,000 when the Fed last cut rates. This shift has increased the likelihood of a rate cut this month.

Looking ahead, markets expect a swift path for policy easing, with 75 bps of total cuts by year end and another 75 bps in 2026. This contrasts sharply with the Fed’s June projections, which indicated three total cuts through 2026. While the Fed’s outlook may have shifted as inflation and employment risks have evolved, market pricing remains notably more aggressive. Based on the Taylor rule, ² the current policy rate is only modestly restrictive. For the Fed to deliver the market’s expected cuts, core inflation would likely need to fall below 2% or unemployment rise above 5%—neither outcome appears likely. There is also considerable uncertainty about how restrictive policy truly is, given the resilience of the US economy. Separately, the Fed’s updated long-term framework signals a more proactive approach to fighting inflation, reflecting lessons from the 2021–22 period when policy lagged. All of this suggests the Fed will be cautious in its approach to easing.

While we expect a gradual easing cycle, a sharper downturn in growth or a significant erosion of Fed independence could prompt more aggressive rate cuts. Although US recession risk appears low, slowing growth and rising cost pressures from tariffs or inflation could further squeeze corporate profit margins and consumer spending. The secular trend of AI has helped counterbalance cyclical headwinds, but this may not pan out as expected. Fed independence also faces its greatest challenge in decades, with the Trump administration repeatedly calling for rate cuts and openly discussing replacing Chair Jerome Powell before his term ends in May. The recent attempt to fire Fed Governor Lisa Cook over alleged mortgage fraud is unprecedented. While legal and policy barriers make it difficult for the president to remove a Fed governor or directly influence policy, heightened political pressure alone tends to result in lower rates and higher inflation over time.

Still, we expect US economic growth to remain positive and the Fed to maintain its independence in setting policy. The Fed should be able to lower rates, but likely less than markets anticipate. In this environment, front-end Treasury yields may decline, while long-end yields could stay elevated as inflation, fiscal, and policy uncertainty keep term premiums high. Narrowing short-term interest rate and growth differentials between the United States and other major economies will likely further weaken the US dollar, which has already fallen this year but remains overvalued. Markets have mostly shrugged off political attacks on the Fed, but any significant erosion of its independence—though not our expectation—would likely compound these pressures, steepening the yield curve and adding to dollar weakness.

Given these dynamics, investors should temper expectations for a rapid Fed cutting cycle. We recommend maintaining a neutral duration stance versus policy and modestly tilting toward non-US assets, such as unhedged developed markets ex US government bonds or global ex US equities, which stand to benefit from a weaker dollar.

Footnotes

1. Bank of England, “Asset Purchase Facility: Gilt Sales – Market Notice 18 September 2025,” Bank of England, 18 September 2025.
2. The Taylor rule is an equation that prescribes a value for the federal funds rate based on inflation and the output gap.

The post Is the Projected Path of Fed Easing Too Aggressive? appeared first on Cambridge Associates.

Moody’s recently downgraded US government debt from Aaa to Aa1, citing persistent, large fiscal deficits and rising debt burdens. While the downgrade reflects fiscal deterioration, it is unlikely to have a lasting market impact. For one, the United States faces no solvency risk, and Moody’s still considers its credit strength exceptional. In addition, among highly rated countries, changes in credit ratings and debt levels show little long-term correlation with changes in government bond yields, which respond more to macroeconomic fundamentals. However, the downgrade coincides with a proposed budget bill that could further widen deficits and increase scrutiny of the US fiscal and economic outlook.

Congressional Republicans are negotiating a budget bill that extends expiring tax cuts, enacts new tax cuts, and reduces spending. The current House version expands the primary fiscal deficit by $3.4–$5.0 trillion over the next decade, according to the Budget Lab. Most of this increase comes from a widely expected extension of tax cuts ($4 trillion), while higher tariff revenues could offset most of the new costs. The Budget Lab estimates tariffs introduced in 2025 would raise $2.7 trillion over ten years, reducing the net deficit increase to $0.7–$2.3 trillion. While their impact may be delayed or limited after a recent federal court ruling struck down most of the new tariffs, the Trump administration retains considerable authority to impose tariffs under current law. As a result, the United States’ average effective tariff rate will likely increase significantly, and tariff revenues should remain sizable. If tariffs are curtailed, the net fiscal and economic impact may be slightly more expansionary, but it will still be more limited than the bill’s headline figures suggest.

Bond markets have been volatile this year, with concerns shifting from growth to fiscal and supply risks. Yields fell early in the year as tariff uncertainty rattled global markets, restoring the negative stock-bond correlation that underpins US Treasury securities’ role as a diversifier. Still, this relationship has been inconsistent. At one point, US Treasury securities briefly sold off alongside equities and the dollar—a rare episode that raised concerns about foreign selling. Although foreign investors have gradually reduced their exposure over time, they significantly increased their holdings in first quarter 2025, even amid heightened US fiscal and policy uncertainty.

Recently, long-dated yields have risen sharply across developed markets, driven by easing trade tensions, improved risk sentiment, and heightened fiscal and policy uncertainty. In the United States, 30-year Treasury yields jumped over 20 basis points in recent weeks, nearing 2023 highs. Back then, the bond market faced similar pressures—Fitch had downgraded US debt after another debt ceiling standoff and inflation was sticky. Today, however, inflation is much lower, the economy appears cooler, the yield curve has steepened, and the term premium is elevated. The US ten-year term premium recently reached 0.92%, its highest in a decade and just below its 1.1% average since 1990. While a one-time bump in inflation from tariffs and continued budget headlines could push yields higher in the near term, the government still has tools to manage the long end of the curve, such as relaxing leverage requirements for banks or issuing more short-term debt. Further, the broader macro environment does not necessitate significantly higher long-dated yields, which should help support demand and limit further increases.

Looking at the bigger picture, despite recent fiscal and policy concerns, the United States’ status as the world’s largest economy, deepest financial market, and reserve currency suggests US Treasury securities will likely remain among the most effective diversifiers during future periods of equity stress. Since 1973, US Treasury securities have appreciated in ten out of the last 11 global equity bear markets, with a median return of 5.6%. Still, no “silver bullet” macro hedge exists—certain environments, such as stagflation or periods of broad US asset or dollar weakness, can challenge even US Treasury securities. For example, while US Treasury securities appreciated during the drawdown in global equities earlier this year, they returned only 2.0%, which is less than usual and trailed both unhedged global ex US Treasury securities (2.1%) and gold (2.5%).

Ultimately, US Treasury securities continue to offer attractive diversification benefits and should remain a core anchor in portfolios. However, recent developments highlight the importance of not relying on any single asset as a universal hedge. Investors can strengthen downside protection by pairing US Treasury securities with other defensive assets, creating more resilient portfolios across diverse market conditions.

Footnotes

1. Bank of England, “Asset Purchase Facility: Gilt Sales – Market Notice 18 September 2025,” Bank of England, 18 September 2025.
2. The Taylor rule is an equation that prescribes a value for the federal funds rate based on inflation and the output gap.

The post Do Fiscal Concerns Undermine the Role of US Treasury Securities as Core Portfolio Diversifiers? appeared first on Cambridge Associates.

In today’s dynamic environment, strategic thinking and flexibility are essential. This edition of VantagePoint revisits the core principles of best-in-class investment strategies, exploring how investors can allow wealth to compound by remaining disciplined, diversified, and focused on long-term opportunities while adapting to change. We explore the fundamentals of investment policy development, including conducting an enterprise review to understand investment goals and objectives, setting a flexible policy framework, and revising policies as needed. Additionally, we highlight best practices in portfolio construction and examine how investors can adapt their strategies to navigate today’s challenges and seize emerging opportunities.

Good Investment Policy Starts with Understanding Objectives and Constraints

Successful investors share a key trait: the discipline to adhere to a long-term strategy through both favorable and challenging times. However, there is no universal strategy that fits all. Each investor’s approach must be tailored to their unique return objectives, risk tolerance, financial constraints, investment expertise, time horizon, and resources.

The foundation of any investment plan begins with an enterprise review—a comprehensive evaluation of financial circumstances, risk attitudes, and governance considerations. This process clarifies objectives, constraints, and potential vulnerabilities, helping to mitigate surprises during crises. For institutions, this might involve assessing how asset pools support operating budgets or reliance on endowments. For families, it could mean prioritizing wealth building for future generations, current consumption, or philanthropic goals.

These priorities must also account for evolving portfolio requirements, particularly under stress. For example, institutions facing reduced government financial support may require more support from endowments, while higher interest rates may prompt pension sponsors to accelerate liability hedging as funding ratios improve.

Key considerations include operating liquidity, balance sheet flexibility, liabilities, debt structure, external liquidity access, cost structure, and income or revenue streams. Qualitative factors, such as stakeholder risk tolerance, are equally critical. Balancing short-term portfolio volatility with long-term purchasing power, addressing illiquidity constraints, and aligning with spending, debt management, and other priorities are essential to effective investment planning.

The Primacy of Policy

After completing the enterprise review, the next step is to develop an investment policy, including the formulation of a strategic asset allocation (SAA). An investment policy serves as a ten-year business plan, providing guiding principles and direction, while remaining flexible to adapt to evolving market conditions, assumptions, and execution. SAAs are not fixed anchors but dynamic frameworks that should be reviewed and refined periodically to account for long-term trends.

Historically, SAAs have regularly adapted to changing conditions as reflected in the median target policy allocations below. The most notable shifts have been large increases in target allocations to private equity and venture capital (PE/VC) that provide significant value-added return potential, funded primarily by reductions in public equities. By increasing these allocations, investors have been able to maintain high return expectations even as falling interest rates lowered return expectations for bonds.

Similarly, actual allocations across endowments and foundations in our database reflect sensible shifts. For example, as bond return expectations fell, investors reduced bond allocations and reallocated hedge fund exposures toward absolute return strategies less correlated with equity risk, while trimming equity long/short strategies.

In addition to adapting to capital market circumstances, changes in investment policy often reflect evolving circumstances, such as tax considerations, significant endowment gifts, or shifts in financial strength. Flexibility in portfolio targets and allocations is critical to improving the likelihood of meeting performance objectives as conditions change.

Investment policies should align with the investor’s philosophy and governance structure. Greater latitude for portfolio implementers (e.g., investment staff, outsourced CIOs, or advisors) and longer evaluation horizons typically require less detailed asset allocation policies, allowing for more flexibility in execution.

We begin building investment policy with a foundational framework, such as a 60% equities/40% bonds or 80%/20% volatility-equivalent profile. From this base, we seek opportunities to enhance returns, while maintaining or lowering risk. Some investors may define SAA simply as a stock/bond policy, while others incorporate more detailed categories based on asset classes, objectives (e.g., growth, diversifiers, liquidity reserve), or a hybrid mix. For example, growth assets may be divided into public and private investments. This level of detail fosters alignment among stakeholders, ensuring a shared understanding of objectives, risk parameters, and strategy. Strong governance and clear expectations help keep portfolios on track and aligned with the investment committee’s intent.

Best Practice Portfolio Construction Features

Successful investment strategies begin with a well-designed policy tailored to investor needs and flexible enough to adapt to changing market conditions. Whether through adjustments to SAA, implementation decisions led by portfolio management, or through external asset managers, the following best practices guide our approach to compounding wealth over time:

• Maintain a long-term horizon to capitalize on illiquid asset classes with more potential for value-added returns.
• Use external best-in-class managers and foster lasting partnerships.
• Diversify to enhance long-term risk/return characteristics beyond a simple stock/bond portfolio.
• Adopt contrarian positions with asymmetric return potential by investing in undervalued assets and dislocated markets.
• Define and manage key risks aligned with constraints and objectives identified in the enterprise review.

Playing the Long Game

Maintaining a long-term investment horizon is one of the most challenging yet essential aspects of successful investing. Understanding the historical behavior of markets helps investors set realistic expectations for portfolios and resist the impulse to sell assets or managers based on short-term underperformance. For example, a diversified portfolio with a nominal expected return of 10% and a standard deviation of 13% would see annual returns ranging from -3% to 23% two-thirds of the time. While short-term volatility is inevitable, the range of expected returns narrows over longer horizons.

A long-term perspective enables investors to access illiquid asset classes—such as
PE/VC—which offer greater value-added return potential compared to liquid, efficient public markets. As demonstrated below, the best-performing investors over the long term have consistently maintained higher allocations to these private investments.

Additionally, a long horizon also allows investors to capitalize on undervalued investments. Doing so requires a strong stomach; sharp market dislocations can be quick to reverse, but absent those, valuation disparities are often slow to revert to fair value. Thus, careful judgment is required to avoid value traps. In general, absent other criteria that may serve as catalysts, a seven- to ten-year horizon is advisable. Momentum is also a powerful force and can be a helpful supplement to identify turning points.

Sourcing Best-in-Class Managers

Even the best managers experienced a difficult period relative to passive benchmarks, especially in the large-cap US equity market, given the concentration of performance in the Magnificent Seven heavyweights in recent years. Greater dispersion of returns across stocks globally should increase the ability of skilled managers to outperform. We believe active management can outperform passive benchmarks, particularly in less efficient markets, if investors: 1) employ a rigorous manager research process, 2) exercise patience, and 3) build well-diversified portfolios to reduce unintended risks. Building outperforming portfolios using active managers is hard work but worth the effort.

Engaging in deep research to identify firms with a repeatable competitive edge and strong organization that can stand the test of time is far more relevant than analyzing short-term performance. As the technology and regulatory environments have leveled the playing field for accessing corporate information, managers must work harder to gain an edge. Technology acumen can provide an advantage, but managers must continually invest to maintain their lead. Experience and judgment also go a long way to set managers apart. From an organizational perspective, we advise partnering with firms that have good governance, thoughtful alignment, a strong culture, and a well-diversified customer base of a high caliber. Securing fee structures that enable investors to retain most of the value-added returns also increases the odds of earning excess returns over the long term.

Patience in active management is key, as even the best managers experience periods of underperformance. Behavioral mistakes, such as firing managers after short-term losses, can erode returns. Staying the course through cycles is essential for long-term success.

Dispersion of long-term returns varies by asset class, with more inefficient asset classes exhibiting greater dispersion across managers. The following exhibit shows the importance of manager selection, especially for private investments where manager return spreads are materially wider than for liquid, more efficient asset classes. ³

Sticking with Diversification

No one can argue with the fact that putting 100% of risk capital in US equities over the 15 years ended 2024 would have been a brilliant strategy. The MSCI US Index returned 13.9%, outperforming the MSCI All Country World Index by 4.1 percentage points (ppts) per year, in US dollar terms. However, such concentrated positioning is risky and subject to sharp reversals amid any change of fortune. Indeed, year-to-date through April 8, lofty valuations combined with prospects for implementation of the highest effective US tariff rates in more than 100 years have seen US equities underperform global ex US equities by roughly 12 ppts, in US dollar terms.

Diversification is a long-term strategy. While a simple portfolio may outperform periodically, a diversified portfolio is expected to generate higher returns over time at a given level of risk—the proverbial free lunch. To better understand the value-added potential of diversified portfolios, we compare the return profile of a simple portfolio of 70% global equities and 30% US government bonds to a highly diversified portfolio constructed to have roughly the same level of volatility as the 70%/30% portfolio. The highly diversified portfolio is expected to outperform the simple portfolio by 100 basis points (bps) over the long term, but could underperform by as much as 100 bps to 200 bps per year over shorter periods. Based on a conservative estimate using indexes to represent asset class returns, over periods of five years or longer ended in 2024, a representative diversified portfolio has outperformed the simple portfolio despite underperforming over the last three years.

The higher expected return for the diversified portfolio reflects the ability to earn incremental returns from various sources, including private investments and pursuit of more diverse market risks. Even after spending more over time, ⁴ highly diversified portfolios are expected to create more wealth through the benefits of compounding. This effect is particularly pronounced over longer horizons.

Tilting Tactical

Another lever that can be used to build returns is tactical asset allocation. This typically involves shorter-term horizon positions that require in-depth analysis, a disciplined process, and risk controls. To develop an investment thesis and exit strategy, it’s important to carefully analyze the historical relationship between the overweight and underweight positions and the environments in which the positioning tends to outperform. Positioning should be sized thoughtfully, scaled by the degree of risk inherent in the position. Ideal positions have higher upside than downside, which is usually derived by relatively attractive pricing for the overweight position. Market dislocations often provide opportune times for initiating tactical positions, so studying asset class relationships and being prepared to take opportunities when they arise is beneficial.

Measuring and Managing Risks

The fundamental purpose of risk management is to provide a clear path for risk assets to compound and build wealth over time. Understanding the portfolio requirements to meet associated spending and liabilities is critical to successful portfolio management. Effective portfolio construction requires identifying and managing risks—such as illiquidity, equity beta, total portfolio standard deviation, drawdown risk, and pension funding shortfall risk—directly, rather than relying on heuristics. For instance, not all public equity portfolios are equally liquid, with emerging markets small-cap and frontier markets equities among the least liquid and US large caps, among the most liquid. Key risks should be identified during the enterprise review and incorporated into investment policy. Management of these risks should focus on taking the right amount, not just limiting risk. Failure to take enough risk could result in underperformance.

Stress testing portfolios to evaluate their resilience under a range of challenging scenarios is a critical component of policy setting and ongoing risk management. The ability to navigate bear markets depends on several factors, including portfolio liquidity, diversification, liquidity needs during periods of stress, and access to external liquidity sources. Such assessments should be repeated regularly over time as conditions change. For example, investors have increased their equity exposure and portfolio illiquidity over the last decade. Understanding how these changes relate to any changes in liquidity requirements especially during times of stress is a core component of portfolio management.

For instance, as demonstrated below using a stylized portfolio reflecting index returns, a $500 million long-term investment pool entering a 2008-like bear market would have meaningfully less portfolio liquidity available to meet cash needs if it had a 50% allocation to illiquid assets compared to a 25% allocation, despite outperforming by about 5 ppts during the drawdown. A high allocation to illiquid assets may be desirable, particularly if the institution can construct a high-performing private investment portfolio. Sustaining such a high allocation requires careful attention to liquidity sources and uses.

The example below shows asset allocation changes before any assets are sold to support cash needs. The ratio of liquid assets including stocks and high-quality bonds to annual cash needs would be 3x, compared to 5x for the less illiquid portfolio. The relatively high allocation to high-quality bonds would have provided a lifeline for the more illiquid portfolio, covering nearly two years of cash needs. Higher cash needs would constrain the ability to maintain a high allocation to illiquid assets, while lower cash needs facilitate such positioning. As a general guideline, bear markets tend not to last longer than three years without recovery, so 3x coverage of cash uses with cash sources (inside and outside the portfolio) following a bear market decline is a reasonable target. Under conditions of limited liquidity, the ability to capitalize on market dislocations would largely depend on existing managers, a factor that should be carefully considered during portfolio construction.

Risk management also extends to implementation. Using external managers to add value requires understanding how individual managers interact and align with benchmarks. Unintended risks—such as geographic, currency, economic sectors, and factor exposures (e.g., value, momentum)—can undermine returns if not carefully managed.

Adapting to Change

Portfolios have historically evolved in response to long-term trends, such as US equity and dollar outperformance since 2010, falling interest rates since 1982, and declining geopolitical risk since the 1990s. These shifts have led to increased allocations to large-cap US equities, greater US dollar exposure, reduced fixed income, and fewer hedge funds. As we move through 2025, diversification is showing signs of renewed value, and investors must assess how their portfolios would fare in the event of a reversal of these trends. We review changing economic and market conditions on an ongoing basis, regularly sharing our views on investment implications. All of these long-term trends have potential to shift the investment landscape in unforeseen ways as they evolve and interact with each other. Indeed, the evolution of global trade conditions will influence fiscal and monetary policy, the ability of countries to finance their debt, and the cost and access to materials and technology to fuel AI developments. We focus here on key implications of the end of ZIRP, challenges and opportunities in private investments, and the role of AI. Other increasingly significant factors that can influence markets and investment outcomes include shifting global trade dynamics, geopolitical risks, and climate change. Investors should remain diversified and vigilant, and incorporate these considerations into their strategic planning.

The end of ZIRP has significant portfolio implications. Higher rates suggest improved fixed income returns, but investors must carefully evaluate credit risk. Weaker credits that borrowed short term with an expectation that rates would remain low indefinitely may find their balance sheets stressed. Indeed, the market sell-off has started to pressure credit spreads in some segments of the market. We would seek to take advantage of such opportunities once spreads reach more distressed levels, including through credit opportunity funds or distressed managers that have requisite experience through investing over prior distressed cycles. Strategies like asset backed lending and insurance-linked securities can help diversify away from corporate credit risk and offer attractive spreads.

We regard high-quality sovereign bonds, particularly US Treasury bonds, as the primary part of a deflation hedge or liquidity reserve allocation. However, we acknowledge that such bonds could come under pressure due to rising interest expenses and fiscal imbalances absent successful efforts to improve debt dynamics. Treasuries served their role well this year until this week, providing much needed ballast to portfolios. However, this week saw significant Treasury volatility for technical reasons, amid an unwinding of leveraged positions. The US dollar has been reasonably stable after initially softening this year. However, US dollar weakness may resume for several reasons including concerns over US growth prospects and the tarnishing of the US exceptionalism consensus that has poured capital into US capital markets over recent years. With prospects for more fiscal and monetary stimulus in the EU and China and heightened policy uncertainty in the US, diversified global equity allocations are more compelling. US Treasury bonds remain a core defensive asset, yet diversifying with other defensive assets like inflation-linked bonds and trend-following strategies can provide similar returns with stronger downside protection.

Higher rates also enhance the appeal of hedge funds. In the early 2010s, endowments and foundations allocated nearly 25% of portfolios to hedge funds, a figure which has since dropped to 16%–17%. Equity long/short hedge funds (ELS) saw the largest decline, but we anticipate a brighter future for these strategies. Higher rates improve returns on collateral, short rebates, and equity dispersion, creating opportunities for skilled stock selection. Disruptive trends—such as shifting global trade relationships, advancements in AI, and the energy transition—are likely to sustain this dispersion, benefiting active managers with strong shorting capabilities. While the HFR Equity Hedge Index still underperformed long-only global equities in higher rate periods, equity dispersion provides the opportunity for strong manager selection to close the gap. Indeed, what matters is achieving equity-like returns over the investment cycle, not matching equity returns in any one period.

And of course, higher rates pose challenges for leveraged strategies like buyouts, requiring general partners to focus on improving operating margins and revenue growth to offset higher capital costs. While valuations remain elevated, they have moderated from ZIRP-era highs.

More broadly, we expect private investment performance to improve as the impact from funds’ rapid deployment of capital into overvalued assets in 2021–22 recedes. Current conditions will likely see some improvement in relative performance as market corrections have a lagged and muted impact on private investments relative to public markets. Yet, the widely expected improvement in IPO and merger & acquisition prospects may need to wait as the current environment is not conducive to improvement in the exit environment. These conditions are ripe for bringing attractive buying opportunities in the secondary market.

Disciplined investors should not be deterred by the recent underperformance of PE/VC relative to public markets. Private markets continue to offer compelling opportunities, particularly for managers with strong operational expertise. The advantages of operating outside the public market’s quarterly reporting pressures remain intact. However, investors should be mindful of the growing retail interest in private investments, which could lead to crowding at the larger end of the market. Further, investors must be exceptionally discriminating if considering investing in supersized funds, given the significant revenue to these managers through management fees relative to carry and the greater difficulty in delivering top quartile returns with very high assets under management. In private investments, effective implementation is critical to generating value-added returns that justify the illiquid, long-term exposures and the significant resources required for success.

Technological advances in AI have potential to create significant value across all sectors over time. To date, much of AI’s impact has been concentrated in public companies—namely chipmakers (e.g., Nvidia, Taiwan Semiconductor) and hyperscalers (e.g., Amazon, Alphabet)—and venture capital. Over time, opportunities will expand as AI integrates into broader industries. Private equity strategies can leverage AI to unlock value in low-margin businesses, while public companies across sectors—such as security, data analytics, and software—will increasingly adopt AI tools. Hype around generative AI’s capabilities has lifted valuations in the near term, but longer term, the transformative potential of AI underscores the importance of staying attuned to technological developments.

Conclusion

In the face of uncertainty, the investment planning process should embrace humility and avoid the pitfalls of overconfidence. For high total return–oriented investors, our approach combines the stability of a predominant allocation to equities and equity-like investments with a diversified and flexible approach. While the aggregate allocation to these growth-oriented assets should remain relatively constant, their composition should be diversified and adaptable, evolving in response to attractively valued opportunities and focusing on identifying best-in-class managers. Without adequate diversification, portfolios risk becoming overly concentrated and excessively volatile. Similarly, diversifying assets should encompass a range of strategies, with allocations shifting toward the most compelling opportunities as they arise.

For taxable investors, the cost of adjusting asset allocations can be significant, shaped by factors such as trust structures, tax status, and the availability of losses to offset realized gains. As a result, any shifts in asset allocation should be carefully evaluated, ensuring that the expected benefits outweigh the associated costs.

In a world defined by shifting economic regimes, technological disruption, and evolving market dynamics, investors must embrace a strategic, flexible, and forward-looking approach to portfolio construction. By adhering to core principles—such as maintaining discipline, embracing diversification, and managing risks thoughtfully—investors can navigate uncertainty and capitalize on emerging opportunities. Adapting to change is not just a necessity but a competitive advantage, enabling investors to build resilient portfolios that align with their long-term objectives. As the investment landscape continues to evolve, those who remain vigilant, innovative, and committed to their strategy will be best positioned to succeed.

Footnotes

1. Bank of England, “Asset Purchase Facility: Gilt Sales – Market Notice 18 September 2025,” Bank of England, 18 September 2025.
2. The Taylor rule is an equation that prescribes a value for the federal funds rate based on inflation and the output gap.
3. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
4. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.

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Markets have reacted sharply since US President Donald Trump announced his reciprocal tariff plan on April 2. Global equities have fallen 16.5% from their February peak, while ten-year US Treasury yields declined as much as 70 basis points (bps) over roughly the same period. Bond yields reflect weaker growth expectations and the market’s anticipation of aggressive Fed easing. Federal funds futures now price in 100 bps of rate cuts by year end, double the Fed’s March projections. However, the Fed may disappoint markets by moving more cautiously, given the announced tariffs complicate the outlook. Initial estimates suggest tariffs could reduce US real GDP growth by 1 percentage point (ppt)–2 ppts but increase inflation by up to 2 ppts. This stagflation shock challenges the Fed’s ability to act decisively, as it must weigh inflation risks against growth concerns. While the Fed cut rates during the 2018 tariff episode, it is less likely to do so now due to heightened inflation risks. Fed Chair Jerome Powell recently emphasized that the central bank is still not in a hurry to lower rates despite the recent market volatility.

To be clear, this is not a repeat of 2022. At that time, the Fed was aggressively hiking interest rates in response to a spike in inflation caused by both a supply shock and pent-up demand following the pandemic. In contrast, the Fed lowered its policy rate by 100 bps in the past year in response to declining inflation and a normalization in the labor market. The Fed’s current target policy rate range of 4.25%–4.50% remains restrictive, well above its longer-run neutral rate of 3.0%. However, it paused further rate cuts following its December 2024 meeting to assess the impact of previous actions. While tariffs add complexity to this assessment, the Fed maintains an easing bias and the bar for rate hikes remains high.

There is a risk the Fed acts too late if it waits for clear signs of labor market weakness in response to tariffs. Recent data suggest the US labor market was reasonably strong ahead of the tariff announcement. The Fed faces a key challenge: forecasting the impact of tariffs on the labor market as most labor market data are either coincident or lagging indicators. This complicates the Fed’s decision making. The Fed will likely closely monitor timely indicators—such as survey data on hiring intentions or qualitative insights from its regional banks—for early warning signs about the labor market. So far, these indicators suggest softness but not outright distress. Heightened credit, liquidity, or funding market stress could prompt the Fed to intervene sooner, potentially through measures like expanded liquidity lines, quantitative easing, or other unconventional measures. However, the Fed will be hesitant to cut rates decisively absent a material increase in downside growth risks relative to upside inflation risks.

Bonds have been a reliable safe haven during the initial equity sell-off, but stagflation risks and tariff uncertainty have introduced volatility. Despite the potential for near-term fluctuations, bonds remain a critical diversifier. Tariffs may have a temporary US inflationary impact, but they could ultimately prove deflationary depending on their effect on the real economy. If recession risks grow, the Fed has room to cut rates significantly, as it has done in past downturns. Still, if a recession develops, then equities have more downside and Treasury securities should provide further protection. For example, US equity prices have fallen 18.0% from their February 19 peak through yesterday’s close. Comparatively, previous bear markets without a recession average a 23% decline, while those with a recession average a 39% drop. ⁵ Bonds, meanwhile, have returned just 3% on average during equity bear markets without a recession, compared to 14% during recessions.

In sum, the Fed will likely wait for clear signs that the labor market is deteriorating before cutting rates. At that point, we could already be in a recession. In that eventuality, the Fed has ample room to cut rates, making bonds a reliable diversifier. Investors should maintain bond allocations at policy target weights.

Footnotes

1. Bank of England, “Asset Purchase Facility: Gilt Sales – Market Notice 18 September 2025,” Bank of England, 18 September 2025.
2. The Taylor rule is an equation that prescribes a value for the federal funds rate based on inflation and the output gap.
3. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
4. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.
5. For US bear markets, we include price decline greater than 19%, as opposed to the typical definition of 20%, to increase the number of observations.

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Most Major Central Banks Should Continue Easing in 2025

Celia Dallas, Chief Investment Strategist

Moderating inflation and near-trend economic growth will allow most major central banks to bring policy rates toward neutral in 2025. Market expectations have fluctuated throughout the year and are now more aligned with central banks. Consequently, we expect the upside for sovereign bond performance is likely limited.

The US Federal Reserve initiated its easing cycle with a 50-basis point (bp) cut in September, responding to a labor market slowdown and reduced inflationary pressures. Similarly, the European Central Bank (ECB) and Bank of England (BOE) have cut rates, driven by weak domestic growth and decelerating, yet still elevated, inflation. Japan is an exception, facing continued inflationary pressure exacerbated by a weak currency and slow economic growth. The Bank of Japan (BOJ) has signaled its commitment to gradually increasing policy rates.

Moderating inflation in 2025, even if it remains above target rates, gives central banks the leeway to cut policy rates, increasing the likelihood of a soft landing. While central banks are not fully transparent about their policy plans, their estimates of the neutral rate, or R*, provide insight on their intentions. Indeed, the Fed’s median Federal Open Market Committee (FOMC) members’ long-run policy rate expectation is 2.9%, equivalent to their current R* estimate. The Fed anticipates a gradual approach to reach R*, aiming for 2026, based on their latest released estimates. The ECB and BOE have less distance to ease to reach neutral, while the BOJ needs to move in the opposite direction. Still, markets are pricing in easing of roughly 85 bps in the United States and the United Kingdom and 148 bps in the euro area.

Market expectations have converged toward those of central banks over the last year and now look reasonable based on current growth and inflation conditions. We reckon expectations will remain volatile as policy uncertainty stemming from the US presidential election results have broadened the range of potential economic outcomes.

Bonds Should Outperform Cash in 2025

TJ Scavone, Senior Investment Director, Capital Markets Research

In 2025, bonds will likely outperform cash, driven by supportive economic conditions and attractive valuations. However, the outcome of the US presidential election could counter these tailwinds if Trump fully implements his policy proposals. Consequently, we maintain a neutral stance on high-quality bonds and duration exposure.

Cyclical conditions support high-quality bonds. Inflation has declined and the imbalances in the labor market have closed, while we expect economic growth to remain close to trend across developed markets. This scenario increases the likelihood of continued disinflation. As a result, we anticipate lower policy rates next year as central banks focus more on labor market weaknesses than inflation. As this happens, cash yields will likely fall below bond yields, making cash less attractive. High-quality bonds typically deliver higher returns, both in absolute terms and relative to cash, when inflation and growth slow, central banks ease monetary policy, or the yield curve slopes upward. Most of these conditions are moving into place heading into next year.

However, the US presidential election outcome could somewhat offset these factors. Trump’s proposed policies on taxes, tariffs, and immigration likely pose an upside risk to bond yields if fully implemented, all else being equal. This concern contributed to ten-year US Treasury yields rising roughly 40 bps in recent months. As a result, some of this risk is now reflected in the price and yields are beginning to look somewhat elevated compared to economic fundamentals. US ten-year Treasury securities currently yield 4.2%, which is above our estimated fair value yield of 4.1%. Furthermore, while these policies could temporarily inflate consumer prices, their impact on growth is more uncertain and could detract from GDP growth next year.

Given this uncertainty, we recommend a neutral allocation to high-quality bonds. While we do not see enough evidence to support a tactical overweight at this time, we advise against reducing exposure in favor of shorter-duration assets or cash, given cyclical tailwinds and attractive valuations.

Inflation-Linked Bonds and Nominal Bonds Should Deliver Similar Returns in 2025

TJ Scavone, Senior Investment Director, Capital Markets Research

Inflation-linked bonds (linkers) are set to generate solid returns in 2025 due to higher real yields and favorable global economic conditions. While we expect disinflation to continue, we also anticipate breakeven inflation rates will remain rangebound. ⁶ Therefore, we believe linker and nominal bond returns will be similar next year.

The real yield on the Bloomberg World Government Inflation-Linked Bond Index reached 1.5% as of November 30, which is back within its pre-Global Financial Crisis (GFC) range. With real yields well above zero, linkers once again provide a positive real return and serve as a viable inflation hedge. In fact, linkers are among the few major asset classes we expect to deliver positive real returns in another inflation shock, according to our scenario-based return projections.

In 2025, linkers should benefit from similar cyclical tailwinds as nominals. However, linkers tend to outperform nominals when inflation expectations rise. The next year looks mixed in this regard. Inflation has fallen substantially from its post-pandemic peak, and we expect it to continue moving toward central banks’ targets. This will likely cap market-based inflation expectations. Currently, ten-year breakeven inflation rates in the United States are 2.3%, which is firmly within their post-pandemic range. On the flipside, we see limited room for breakeven inflation rates to fall below their post-pandemic lows absent a recession. As such, we expect breakeven inflation rates to remain rangebound in 2025.

A supply shock would likely benefit linkers, but these are hard to predict. For example, the escalation of the conflict in the Middle East has not challenged supply chains or the production of key resources like oil as some expected. Tariffs are another unknown. While they increase consumer prices, their effects are temporary and are unlikely to sustainably lift inflation expectations.

In summary, we believe linkers will generate solid returns in 2025, but we do not see a compelling case to overweight or underweight them versus nominal bonds.

Footnotes

1. Bank of England, “Asset Purchase Facility: Gilt Sales – Market Notice 18 September 2025,” Bank of England, 18 September 2025.
2. The Taylor rule is an equation that prescribes a value for the federal funds rate based on inflation and the output gap.
3. Comparisons of private investments and public investments are not quite apples-to-apples. We show private investment manager returns using horizon returns based on internal rates of return and compare them to time-weighted returns for liquid investments. While imprecise, the analysis is directionally correct and consistent with our investment experience.
4. We assume both portfolios have a beginning market value of $100 million and spend 5% of a 12-quarter moving average of ending market values.
5. For US bear markets, we include price decline greater than 19%, as opposed to the typical definition of 20%, to increase the number of observations.
6. The spread between nominal and real yields.

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