Q4 2025 - The proverbial tree falling in the forest

If the economy expands and no one is there to calculate the growth, does the market make a sound? That was the conundrum for 43 days—about  half of the 4th quarter—during the 2025 government shutdown. Markets were deprived of the typical economic statistics they rely on so heavily. No monthly job numbers, no inflation data, no PCE data from October 1 to November 12. Even when the government reopened in mid-November, the data spigot was not immediately opened—the stream took some time to resume, particularly when considering quality and robustness. The markets had lived through shutdowns in the past, but this one was longer and more data limiting than any in history.

Was the bond market shut down as well?

At least by two broadly utilized metrics, it almost appeared that the bond market was also closed. The 10-year Treasury yield to maturity (YTM) began the quarter at 4.15% and ended at 4.17% , a net movement of 2 basis points (bps). The spread on the Bloomberg Investment Grade (IG) Corp index over Treasurys experienced a net change of only 3bps. The only part of the bond market that experienced material net change was the yield curve. As noted above,  the 10 year Treasury YTM was largely unchanged, but short rates declined by 25bps and 30 year YTMs actually increased by 10 bps. The Bloomberg Aggregate Bond Index ended the quarter with a respectable return of 1.10% and a solid 7.30% for 2025.

Diversified investment process helps

This 35bps of “twist” steepening was positive for our Fixed Income portfolios as the Yield Curve Alpha Pod Committee, exercising the greatest allocation of our overall Q4 risk budget, was correctly positioned for the steepening environment. While over full cycles it is somewhat unusual for yield curve to be the dominant factor in fixed income performance attribution, the 4th quarter’s steepening ensured that yield curve has provided a strong source of excess return for our portfolios in each of the last three years. Since July of 2023, the curve has moved from a significant inverted position to its current positive slope, totaling 250bps of steepening between 2-year notes and 30-year bonds.

Is the economy O-K?

Economic growth appears to have remained resilient during the second half of 2025, even through the government shutdown. In fact, the Atlanta GDP Now suggests Q4 Real GDP could come in over 4%, significantly higher than the 2-3% most forecasters had predicted. While the various job data that the market did have access to—much of which came from private sources—seem to contradict the overall strength portrayed by GDP, the number makes more sense when you decompose the components. 

First, two of the four categories  - Investment (I) and Net Exports (NX) in the  “C+I+G+NX” GDP calculation scored high marks (think: AI spend and impacts from tariffs). Second, when looking at what is generally the largest contributor, consumption ( “C”), it is very stratified (G is government purchases). Most estimates suggest that the top 50% of income earners have comprised 80% of the total consumer consumption, with the top 10% accounting for 50%. This breakdown—referred to as the ‘K-shaped’ economy—makes optimal monetary and fiscal policy decisions more challenging, and thus could lead to increased bond market volatility in 2026.

What to watch for

While much progress has been made on inflation over the past 24 months, an analysis of the data suggests that most measures are closer to 3% than the Fed’s stated goal of 2%. The ‘K-shape’ often amplifies this difference by conflating inflation with affordability. Will the Administration be forced to stray from supply-side policies in order to react to more populist rhetoric as the ’26 mid-terms approach? Policy moves such as $2,000 tariff dividends for middle and lower income families; housing policy adjustments in attempt to lower mortgage costs; and 10% credit card interest rate caps are all fairly big measures that have been floated to try to accommodate the lower part of the ‘K’. Add to that, potential geo-political events (Venezuela, Greenland, Iran and Ukraine) and you have a landscape that current markets may not have a firm grasp on. Last but not least, the independence of the Federal Reserve remains somewhat precarious. 

Where will alpha come from in ’26?

Historically in such environments, we have found it beneficial to rely more on value than momentum techniques as inflection points can become more frequent. With rate levels somewhat normalized on both an absolute and relative level, and a yield curve with a traditional positive slope, we have reduced our interest rate bets. Thus, our focus has turned to sector spreads which appear to be at or near historic tights. In general, this leads us to want to own less overall credit than our benchmarks, and when we do choose to own, we look to be very diversified, utilizing out-of-index sectors (ABS, Bank Loans, Trade Finance, EM), in conjunction with the primary sectors such as MBS, IG and US high yield. In this type of environment, security selection in each of the risk sectors takes on added importance. We believe that plays to another of our strengths as we strive to add value in what will undoubtedly be another noteworthy year. 

Read more about our current views and positioning at Fixed Income Perspectives