We believe the Fed will cut rates by 25 basis points in both October and December following them up with two more cuts in 2026. The Fed has delivered on its prior indications of not tolerating labor market weakness, and the material fall in nonfarm payrolls and downward revisions of previous numbers we believe puts it on the path for further easing.
Outside the US, many central banks have reined back on easing following the tariff shock, and instead are focusing on the balance between inflation and growth as we look toward the new year. We anticipate both the European Central Bank (ECB) and Bank of England (BoE) to hold rates steady for the remainder of 2025 but believe that risks skew towards both cutting early next year if inflation undershoots expectations. A contractionary Autumn Budget could even convince the BoE to cut in December.
Elsewhere in the G10, we believe New Zealand still has room to cut given ongoing poor data, while soft growth in Canada informs our view that the Bank of Canada will cut by 25bps at its October meeting, with risks skewed to more easing ahead. By contrast domestic pressures continue to build in Japan regarding high inflation and robust growth, which we think should give the Bank of Japan (BoJ) license to hike in the fourth quarter. We expect easing to continue across several EM economies, helped by continued subdued US dollar and oil prices reducing inflation risks.
Fiscal Risks in Both Directions
Rising political uncertainty has exacerbated worries about government spending over the past quarter. This includes leadership changes in France and Japan, which have cast doubt on their governments’ paths forward in terms of fiscal consolidation, and broader uncertainty over economies such as the UK having weak growth, sticky inflation and rising deficits. However, we also think that the much-heralded German fiscal expansion announced earlier this year could disappoint to the downside, potentially weighing on eurozone growth. The new budget was only approved in September, and the execution risks around it in both timing and delivery could result in disappointment. Looking ahead, we will be closely watching the French and Japanese political developments, the UK Budget in November, as well as monitoring progress on spending in Germany.
A Fragile Balance in the US Labor Market
The marked deterioration in payroll and employment figures, including sizeable downward revisions of nonfarm payrolls data, led to a sharp re-evaluation of the overall strength of the US economy during the quarter. The Fed’s return to easing is framed as “risk management” against this slowdown, with two further cuts penciled in before the end of the year. However, the makeup of the labor market is notably fragile, with fewer people leaving work and fewer people able to find jobs. This “low hiring, low firing” dynamic could be much more sensitive to economic shocks. How the labor market plays out in the near term will likely dictate the course of Fed easing.
The Consumer in the Face of Tariff Passthrough
The AI capex cycle, tariff frontloading and the weaker US dollar helped drive the resilience seen over the past quarter. However, we recognize that some of these factors may not last and are paying particular attention to the health of the US consumer. Companies may start to pass costs through to customers as tariffs become normalized, however the extent to which they can do this is questionable given the considerable weakness shown by the labor market. Similarly, although the AI capex boom has shown significant momentum and acceleration, it remains to be seen whether this will be sustained if the economic backdrop remains febrile. Our view is that the US consumer appears to be bending rather than breaking, and that the status quo can continue with the Fed in risk-management mode. However, we remain cognizant of the downside risks to this view, particularly if the labor market continues to trend downwards.
Interest Rates
The Fed is currently in risk management mode, in our view, putting emphasis on trying to stabilize signs of labor market weakness. The September dot plot indicated that the Fed’s base case was also for two more cuts this year, but with a narrow 10-9 split among the committee. We believe this baseline is firmer than the split suggests however, assuming Powell and other core Federal Open Market Committee (FOMC) members were among those backing two cuts. In Europe, we expect the ECB to remain on hold for the foreseeable future.
Opportunity: Continued policymaker divergence provides investors with the opportunity to express views in different sovereigns across the curve and diversify their duration exposures.
Currencies
While we have entered a Fed easing cycle, there is reason to believe that this will not be structurally bearish for the US dollar. Sticky inflation and bullish US equity markets can provide support and offset falling currency yields the Fed’s dovish reaction function. Historically, the dollar also tends to rally or remain level after an initial Fed cut that isn’t followed by a recession, and we do not expect a significant downturn ahead. Upcoming labor market data and inflation releases remain critical to the dollar’s path looking forward.
Opportunity: Tariff-related inflationary effects and AI-driven equity market performance are positive factors for the dollar; however these are counterbalanced by the Fed easing policy. Overall though we still feel the dollar can rally in risk-off environments, particularly ex-US.
For more information on our asset class views and opportunities for investment grade, high yield credit and banks loans, agency MBS, securitized credit, emerging market debt, municipal bonds, responsible investing, and liquidity solutions download our Fixed Income Outlook.
