In investment parlance, we like to talk in quarters, but the first half of 2025 can really be divided into three distinct periods. The first two months of the year were relatively quiet, with modest movements in interest rates and spreads as the new administration went about setting its agendas. March and the first half of April witnessed a significant risk-off environment as Liberation Day surprised and disrupted markets. Mid-April through the end of the quarter then produced a quick retracement as risk-on re-emerged.
The result? While interest rates ended moderately lower on 30 June relative to the end of 2024, credit spreads ended largely unchanged with fixed-income risk assets back generally where they started the year. It leaves markets in a suspended state of uncertainty and seeking resolution.
Volatility round trip
We titled our January write-up “Volatility, velocity and vigilantes.” In the first quarter, while we saw some of the latter two V’s, we saw an awful lot of volatility. It was most prevalent in the difference between equity and fixed income returns. With the S&P 500 down 4.27% and the Bloomberg Agg up 2.78%, we saw the biggest absolute difference since March 2020 and in that period, it was equities with a positive return and bonds negative.
At the beginning of last quarter, we talked about how sequencing would matter in this game of chess. We believed that the markets would view tariffs as disruptive, while deregulation and tax policy were potentially constructive depending on magnitude. As expected, markets see-sawed without getting firm answers to the open questions. As equity markets ultimately recovered back to record highs, bonds returns improved too. As far as our four Alpha Pod committees’ results, sector positioning gave back some early quarter gains in US high yield, but emerging markets contributed consistently to performance as the US dollar continued to weaken. Our positioning for yield curve steepening continued to add to portfolio performance, and we began the third quarter maintaining a constructive ‘lean long’ on duration.
We also suggested previously that Q2 would probably contain the ‘good stuff,’ setting trade and tariff discussions on the back burner as the One Big Beautiful Bill and extension of the 2017 tax cuts took centre stage. As we begin the second half of the year, the budget is across the finish line, allowing the market to refocus on trade and tariffs, as well as the historic fiscal deficit. We’re back to a focus on future uncertainty, even if it’s been mitigated somewhat by trade deals trickling in.
The new budget for better or worse?
Politically, the final version of the budget bill is not very populist and fairly regressive, with tax cut extensions that accrue in significant portion to high wage and income earners, implicitly financed by spending cuts in areas such as Medicaid and social services. Regardless of where one falls on the political spectrum, the Republicans’ ability to produce the bill within the US administration’s self-imposed 4 July deadline was fairly impressive. The fact that both deficit hawks and moderate Republicans complained throughout suggests that Republicans did ‘thread the needle’ to some degree. It’s also fair to say that predicting the long-term success of the US budget bill depends on belief in supply side economics and the likelihood that the tax cut creates a growth environment dramatically higher than most third-party estimates. The White House Council of Economic Advisers projects that the new budget will help growth achieve over 3.5% – a full 2% more than projections from the likes of, well, professional economists everywhere.
The Federated Hermes fixed income team leans toward the consensus for lower growth numbers. We are somewhat sceptical of any significant progress on the budget deficit as the bulk of the stimulus (tax cuts) occurs immediately, increasing near term deficits. And the projected Medicaid savings and increased tax revenue from ‘extra’ GDP growth come later and thus are by definition less certain.
The labour situation is interesting as a few cross currents now appear to be in place
Tariffs, immigration and the labour component
In general, our views remain consistent with the conventional thought that tariffs increase inflation – albeit somewhat in a ‘transitory’ manner – and they are expected to ultimately slow growth while driving prices higher.
The labour situation is interesting as a few cross currents now appear to be in place. Stricter rules around social benefits (Medicaid, SNAP) are intended to pull potential workers back into the labour force. This will be needed as US demographics, reduced immigration and increased deportations have the opposite effect. The Department of Government Efficiency (DOGE) related federal workforce cuts seemed to find their way into state and local workforces – at least as implied by the most recent non-farm payroll report. How efficiently these impacts balance each other will go a long way in determining the unemployment rate going forward.
Better late than never?
So how does this play out with rates? US President Trump’s off-repeated displeasure with Federal Reserve Chair Powell adds to the probability that Fed rate cuts are coming – either as a final act for Powell, or the opening act of a new dovish Fed chair who will be put in place in 2026. While conventional market reaction to cuts usually results in a bull steepener – longer term rates declining, albeit not as much as short rates – this time the bond vigilantes may not take as kindly if they believe inflation hasn’t progressed to 2% or if they view it as the chair acquiescing to the president’s wishes. Thus, a twist steepener – short rates lower, long rates higher – is a distinct possibility. We saw this type of action after the rate cuts in 2024, where 6 months later, the US 2-year was 41 basis points (bps) lower and the US 30 year was 23 bps higher.
Thus from a portfolio standpoint, our strategic yield curve positioning of a near maximum steepener has a bigger portion of the risk budget than our tactical modest duration long.
Risk premiums
When we think of risky credit sectors, our saying is ‘if it all works, you get your money back.’ And while it all ‘may work,’ as discussed throughout, with the passing of the budget, it’s gotten harder for everything to work.
From a bond market perspective, the challenge in the current environment is there is little risk premium for looming tail risk in credit sectors. Corporate profits are at 10% of US GDP for the first time since before 1929. Our guess is that tariffs, of whatever scope, will help this stat correct, making lower quality corporates less attractive.
The Trump put and Trump call, the ‘Escalate to de-escalate’ will likely continue, as the debate as to whether that represents a feature or a bug will also likely continue. And that gives us confidence that there will be better entry points.
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