Active Fixed Income Perspectives Monthly Pulse: September 2025

Our outlook: Tariffs are gradually impacting the economy, but offsets are on the horizon

The labor market has downshifted, and building tariff impacts drive the risk of a softer economy over the next several months. At the same time, the Federal Reserve is acting proactively, and we foresee more pro-growth policy next year, supporting economic momentum. In portfolios, we are balancing this more benign outlook against full valuations and the risk of the economy slowing more than anticipated in the near term.

The labor market: Realigning to a new equilibrium. Continued slow job growth in August, downward revisions, and a job-openings-to-unemployed-persons ratio under 1:1 for the first time in four years highlight labor market risks. So far, both the demand for and supply of labor have fallen, keeping the unemployment rate in check. AI productivity and other factors may further subdue demand to counterbalance a new normal of low labor growth. However, the current equilibrium is fragile and warrants vigilance.

Tariffs: A slow burn with broad reach. Trade policy is still a key economic catalyst, and its effects are growing, evidenced by rising goods inflation. We estimate about a third of the new tariffs’ impact has passed through the economy already, and we’ll see about half by year-end and the rest in 2026. A slow pace of implementation has helped the economy digest the changes and companies mitigate the impact, but risks to growth and inflation persist.

The Fed: Easing, but with eyes wide open. The recent string of soft labor market data opened the door for the Fed to cut rates by 0.25%. We view the September cut as policy normalization guided by risk management, and we expect further cuts this year and into 2026. However, absent a recession, we do not expect the Fed to deliver all the cuts the market is presently expecting.

Offsetting forces: Growth catalysts on the horizon. Tax cuts and deregulation should help the economy and counteract tariffs’ impact. We forecast the new tax and spending bill alone to add roughly 0.4% to GDP growth next year. Continued investments in and productivity gains from AI, as well as less restrictive monetary policy, may also serve as economic tailwinds.

Our active positioning: A bottom-up focus amid full valuations

Rates: A nimble stance in a shifting landscape. Short-term yields appear too low, as the market may be expecting too many rate cuts. Farther out the curve, risks are balanced between downside risk from labor market vulnerability and upside risk should the growth outlook brighten. We view current 10-year Treasury yields as fair but are biased to lengthen duration should yields rise toward the higher end of recent ranges.

Credit: Tight, but tenable. Credit spreads are near historical lows, but healthy fundamentals, attractive all-in yields, robust investor demand, a proactive Fed, and low recession risk support current valuations. Capitalizing on seasonally higher bond issuance, we have added credit risk across our portfolios and are focused on individual bond selection and subsector allocation.

Municipals: Value in the curve’s steepness. Munis have rallied, and our portfolios benefited from strong coupon and call option selection. The high-grade tax-exempt curve remains steep, offering compelling value and healthy underlying fundamentals. We continue to maintain modestly longer duration against our benchmarks as a hedge to our long credit positions.

Notes:

For more information about Vanguard funds, visit advisors.vanguard.com to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information are contained in the prospectus; read and consider it carefully before investing.

All investing is subject to risk including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. Past performance is no guarantee of future results.

Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer’s ability to make payments.

Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.

U.S. government backing of Treasury or agency securities applies only to the underlying securities and does not prevent share-price fluctuations. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.

Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund’s trading or through your own redemption of shares. For some investors, a portion of the fund’s income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.

CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.