Empire Life Blog 2025 Semi-annual Market Outlook: Fixed income overview

This mid-year update covers H1 2025 fixed income volatility from trade and global economic uncertainty. It details the BoC’s two rate cuts and the Fed’s steady approach, alongside Moody’s downgrade of US debt to AA due to tariffs and deficits.

Overview

 

Fixed income markets continued to experience notable volatility throughout the first half of 2025. Market sentiment was primarily shaped by trade and tariff headlines, which introduced a significant degree of uncertainty into the outlook for global economic growth. The rapid succession of trade policy announcements, including US tariffs on trading partners like Canada, followed by retaliatory measures, contributed to fluctuating market conditions.

A prominent theme in the first half of the year was the divergent paths taken by the Bank of Canada (BoC) and the US Federal Reserve (Fed).

The Bank of Canada implemented easing measures, with two 25-basis-point rate cuts. The first occurred in January, influenced by inflation becoming less broad-based and a softer domestic economic backdrop. In March, anticipating potentially weaker growth after initial tariff announcements, the BoC cut again. This decision reflected restrained household spending and business investment intentions due to tariff threats, along with inflation remaining near its 2% target, which was also influenced by the HST holiday.

In contrast, the Federal Reserve maintained its policy stance, leaving rates unchanged throughout the first half of the year. This approach was based on the perceived resilience of the U.S. economy, as evidenced by a loosening labour market and generally robust consumer spending. Despite the tariff headlines, inflation in the US continued to move lower towards the Fed’s 2% target.

Beyond trade, domestic political events also had an impact. Canada saw the Liberals retain power with a minority government. In the US, the combination of tariffs, their economic impact, and the growing fiscal deficit contributed to Moody’s downgrading the US debt rating from AAA to AA¹. This development meant that no major ratings agency now rates the US as AAA, which generally contributed to an upward drift in yields.

The considerable uncertainty surrounding trade policy, combined with the rapid introduction and subsequent adjustments of policies, fostered a high degree of volatility in fixed income markets. We began 2025 with markets pricing in approximately 1.75 Fed rate cuts and 2.5 Bank of Canada 25-basis point cuts. As US data remained resilient, the number of priced-in Fed cuts initially drifted lower. However, as trade tensions appeared to escalate, markets briefly priced in as many as four Fed cuts before settling back around two cuts for the year. In Canada, cut pricing initially drifted lower ahead of tariff announcements, then increased to 3 cuts at the peak of trade tensions. Since March, Canadian cut pricing has generally continued to drift lower, with markets now pricing in about 1.5 cuts for the remainder of the year.

On the currency front, we observed the Canadian dollar appreciate against the US dollar. This dynamic was more a reflection of the US dollar’s weakness rather than the Canadian dollar’s outright strength. The US dollar depreciated by approximately 9% against a basket of major global currencies, compared to a depreciation of about 5% against the Canadian dollar. US dollar weakness has been influenced by increased expectations of Fed cuts, concerns over the US fiscal position and rising debt, as well as trade and tax policies, and a perceived diversification away from US assets by global investors. 

Investment-grade and high-yield corporate spreads also experienced significant volatility in the first half, with notable widening following “Liberation Day” before subsequently tightening. Corporate bonds rated AAA to single-B have largely tightened back to near start-of-year levels, while CCC-rated corporate bond spreads remain elevated.

Source: Bloomberg, as of May 31, 2025

Outlook

Uncertainty remains a key factor for the

fixed income outlook. We anticipate some continued divergence between Canada and the US, both in economic performance and central bank policy. Central banks are likely to remain highly data-dependent, perhaps with a less forward-looking posture than typical, given the elevated uncertainty. The path forward for forecasting remains unclear, with further easing from either central bank dependent on evolving economic data and the trade landscape.

Stagflation Concerns

In Canada, GDP showed resilience through Q1, potentially boosted by exports being pulled forward ahead of tariff developments. Q2 is likely to be softer, given this pull-forward effect, and this trend may persist into the second half of 2025. Business and consumer sentiment appear to be depressed due to uncertainty, and the labour market remains somewhat weak. On the other hand, rising inflation remains a concern, as core measures and breadth continue to increase, and inflation expectations from consumers and businesses have begun to rise again. While headline inflation may receive some relief from the removal of the Consumer Carbon Tax, underlying inflation remains a key focus, especially as the full impact of retaliatory tariffs has yet to be fully reflected in the numbers. The Bank of Canada is closely observing inflation expectations, the pass-through of cost increases to consumers, and the extent to which US tariffs might reduce demand for Canadian exports. If headwinds to growth ease while inflation remains contained, the Bank could potentially find a path towards further easing later this year. However, we may be nearing a terminal point for this easing cycle, unless there is a dramatic weakening of economic data.

Softening U.S. Economy  

In the US, we are beginning to observe some economic data showing signs of further softening. Soft data points, including PMIs, business and consumer sentiment, and surveys of business investment intentions, remain on the weaker side. Payrolls are gradually weakening, with recent ADP private payroll reports generally coming in below market expectations, and job cuts beginning to rise. The Fed is maintaining its policy stance to address uncertainty, but has acknowledged that the risks of both higher inflation and a higher unemployment rate have increased. We could potentially see some easing in the US, given the period of holding rates steady; however, they must also balance their dual mandate of maintaining maximum employment and stable inflation at around 2%.

The path for fiscal policy also remains somewhat uncertain for both countries. In Canada, we await the fall budget from the new government, but estimates from their costed platform imply a greater issuance in 2025 than in 2024. In the US, given the adjustments on tariffs (which would result in lower tariff revenue) and the limited effectiveness of efforts to reduce costs, we could foresee elevated issuance and borrowing, particularly as the economy was already running quite strong.

Investment Implications

We anticipate stable fundamentals, but spread volatility may increase if recession risks begin to re-emerge. All-in yields for investment-grade credit continue to appear relatively attractive, particularly in the 5–10 year segment. BB and single-B rated high-yield bonds are generally supported by relatively high all-in yields; however, credit selection is crucial to avoid lower-quality issuers with near-term refinancing needs. We maintain a slight preference for defensive sectors over cyclical names, which may be more vulnerable to margin pressure or tariffs.

Download the full Empire Life 2025 Semi-annual Market Outlook (PDF). 

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¹ Moody’s Ratings (Moody’s) Moody’s Ratings downgrades United States ratings to Aa1 from Aaa; changes outlook to stable May 16, 2025

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July 2025