Fixed Income Outlook: Diverging Global Inflation Paths

Market Review and Q3 Outlook

While Trump is likely to persist in sowing chaos and dominating the news cycle, it remains to be seen whether his attention has shifted away from trade policy as we reach the halfway point of 2025. The Israel-Iran conflict may draw focus from domestic issues, but more market-friendly initiatives—particularly deregulation—could be on the agenda, especially with U.S. mid-term elections on the horizon in 2026. The 90-day pause on reciprocal tariffs set to expire on July 9, now appears likely to be extended for countries negotiating in good faith. Mercantilism remains in full effect; the G7 Summit in mid-June should clarify the link between NATO member countries raising defence spending and receiving tariff relief.

As we noted last quarter, a continued soft landing and fixed-income market asymmetry remain our base case. The risk of a “Liz Truss/U.K. moment” and untethering of long bond yields has risen but remains unlikely. Yield curves typically steepen during easing cycles, and fiscal policy, combined with the ongoing risk of tariffs, has pushed long yields higher, even as U.S. growth contracted in the first quarter due to a record drag from net exports and inventory building ahead of tariffs. Sentiment and survey-based economic data, typically used as leading indicators, had been weak through the spring but began to turn more positive as June progressed, while real-time or lagging hard economic data have remained resilient. June’s Consumer Price Index print was the fourth downside surprise which, alongside some tariff clarity, should give the U.S. Federal Reserve (the “Fed”) greater confidence to cut overnight interest rates, provided companies absorb temporary cost increases rather than passing them onto consumers.

Where the U.S. has experienced weakness in soft data, Canada has seen weakness in both soft and hard data. In the second quarter, the Bank of Canada held rates steady at 2.75% for two consecutive meetings, but the seven existing interest rate cuts may be sufficient to ward off recession. Smaller-than-previously expected increases in mortgage renewal rates should help, at the margin, to support consumer spending and bank balance sheets. While economic data remains weighed down by uncertainty and tariffs, core inflation has risen back above 3%. The Bank of Canada is awaiting greater clarity on the economy and inflation before increasing monetary accommodation. The market is currently pricing in only one more 25 bp cut this year.

Following Trump’s tariff announcement in April, Canadian government bond yields bear-steepened. Despite headwinds from tariffs and lower immigration, the long end of the yield curve is underperforming. Provincial and federal governments are increasing fiscal stimulus through deficit spending to help offset economic pressures and diversify trade away from the United States, though this will increase bond supply and could push inflation higher. For the time being, we are leaning toward maintaining or reducing duration. That said, a material deterioration in the economy could cap inflationary pressures and drive additional rate cuts. Should we anticipate such an outcome, we would likely reverse course on duration.

In the rest of the world, European growth has improved but remains below its long-run average. Infrastructure and defence spending, particularly in Germany, should provide additional support. Strong deflationary forces remain—negative population growth, rigid regulations, and high taxes—which should mitigate the inflationary impact of the increased deficit spending. Bond yields have likely peaked. Likewise in China, GDP is tracking well below the government’s 5% growth target, and the government is spending heavily to support the economy. In a new era of tariffs, nearshoring, and friendshoring, China is unlikely to export deflation to the rest of the world as it has done in the past. Japan remains an outlier, with Europe’s demographic challenges and a rigid business culture. Inflation, which finally turned positive in 2022, has proven sticky above the Bank of Japan’s 2% target, even as yen strength has cooled export competitiveness.

Strong fundamentals and a heavily imbalanced supply-demand dynamic will continue to support corporate bonds. Given high all-in yields and significantly improved quality—especially in high yield compared to its historical norms—credit spreads can stay tighter longer than traditional models might suggest. Tight credit spreads could, in theory, encourage borrowers to aggressively lever their balance sheets for share repurchases or acquisitions. However, this is not the corporate behaviour we are currently witnessing (see chart below), nor do we expect it in the near term. The same uncertainty that has stalled the IPO market is prompting management teams to play defence, with several investment-grade issuers tendering for long bonds at prices below par.

Our counsel has been to remain tactical in both government and corporate bond markets, as the Trump Administration continues to use policy uncertainty as a negotiating tool. While we believe the overall direction of government bond yields is lower, the path forward will not be straight line. This is an environment that should reward sound strategy and disciplined security selection over outright risk-taking.

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Source: Bloomberg Finance L.P., Apollo. As of June 9, 2025

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