Record Shutdown, Rate Cuts and Curve Steepening in Q4
Fourth Quarter, 2025
John R. Sides, CFA
At midnight on October 1st, a 43-day shutdown of the Federal government commenced, the longest such event in U.S. history. As a result, for much of the quarter the release of standard economic data was either delayed or postponed indefinitely. Uncertainty around forward Fed policy grew more pronounced. Investors gravitated towards “alternative data” sources in an effort to pick apart the state of domestic growth and inflation but largely found themselves driving in the dark. The torrid rally in risk assets took a brief pause as volatility spiked. Despite the fog, by quarter end equities had pressed higher, and spread sectors performed admirably.
Why? The rally was partly attributable to a pair of rate cuts during the quarter. The Fed delivered one each at the October and December meetings, respectively. In a continuation of third quarter messaging, commentary from Fed officials suggested far more concern for the weakening labor market than for potential inflationary pressure. While recent CPI readings have been relatively benign, moves in the yield curve during the quarter suggest inflation remains a concern. Between easing monetary policy, the end of the Fed’s balance sheet run-off, and positive fiscal impulse from the One Big Beautiful Bill, the market largely expects +2%-3% growth next year and inflation to remain a threat. The curve steepened accordingly.
Even if taken with a grain of salt, the growth data was encouraging. On a sequential basis, third quarter real GDP growth came in at 4.3%, building on the 3.8% annualized rate in the second quarter. Although the actual benefits of AI-driven capital expenditures remain to be seen, the impact on growth data is undeniable. While consumer spending and private consumption are the primary drivers of GDP, the contribution to growth from data center investments has surged. Inflation remained in check. The November reading of Core CPI came in at 2.6% year-over-year, the lowest reading since March 2021. Headline CPI, which includes food and energy prices, printed at 2.7% for November, squarely within the multi-year range.
As we mentioned at the end of last quarter, we have been expecting a steeper yield curve. The difference between the 5-year Treasury yield and the 30-year Treasury yield ended December at 112 basis points, up from 99 basis points on September 30th and 40 basis points at the beginning of the year. Securitized products delivered strong excess returns during the quarter, with agency MBS in the driver’s seat. We expect bank deregulation to provide continued tailwinds for agency MBS in the new year. Credit performance in the quarter was more muted. Financials and utilities outperformed industrials as certain credits in the technology sector pulled back. Going forward, we remain cautious on investment-grade credit valuations despite broadly healthy fundamentals. Crucially, we expect rising dispersion to provide opportunities across sectors and issuers in 2026.
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