The Capital Markets team at PNC provides an analysis of the trends, news, and activity that took place in the market toward the end of 2025 and looks ahead to what may be on the horizon.

Foreign Exchange[*]

Interest rate differentials are starting to take a more prominent role in the fourth quarter due to inflation. We have seen some central banks meet their mandate, allowing them to cut rates in an aggressive manner over the past year. The Bank of Canada (2.25%) and European Central Bank (2%) are top of mind, but there are others that may have to dial back the priced in aggressive cuts. The Federal Reserve (Fed), Bank of England and the Reserve Bank of Australia are all dealing with sticky inflation. As a result of these developments, the currencies have range-traded with the dollar backing away from weaker levels. In addition, the foregone conclusion that the dollar would sell off got a bit too crowded.

Recent support for the dollar includes reduced pressure on Fed independence after signaling/starting rate cuts, and tariff headlines fading after short-term volatility in Q2.  PNC’s trading desk expects periods of U.S. dollar strength to be viewed as potential hedging opportunities.

Key variables we are monitoring include:

  • Global inflation trends and central bank responses
  • The announcement of a new Fed Chair 
  • Fiscal concerns amid persistent government spending worldwide
  • Geopolitical developments, including Russia/Ukraine and Venezuela/Latam
  • Timing the U.S. dollar rotation trade re-emerging

Taxable Fixed Income—Mortgage-Backed Securities (MBS)[**]

Agency MBS spreads saw their largest tightening in Q3 2026, with current coupon spreads tightening by roughly 20bps. This was largely driven by the expectation of two 25bp Fed rate cuts in September and October, which improved funding rates for Agency MBS buyers.

Surprisingly, the shape of the yield curve (spread between 2yr and 10yr Treasury yield) was largely unchanged throughout Q3, holding within a tight 12bp range since Q2 2026. While curve steepening typically supports bank and depository demand, Agency MBS still outperformed due to a 25% drop in rate volatility and a 15–20bp decline in overall yields — implying more stable rate moves, boosting demand for duration and benefiting this negatively convex sector.

Q4 2026 was largely a continuation of trends, with rate and equity volatility (as measured by VIX) continued to decline to multi-year lows, and with it MBS spreads tightened even further, an impressive ~15bps in Q4, bringing the total tightening for 2025 at 25bps…the best performance since 2017. This was possible because of another 25bp cut to Fed Funds rate in December, which improved net-carry, and critically, finally caused the yield curve (2yr/10yr treasury) to break out of its tight range and steepen aggressively in December by ~20bps. This steepening improves deal arbitrage and improves the funding scenario for depositories to purchase agency MBS. 

Taxable Fixed Income—Corporate Bonds [**]

The quarter began with lingering uncertainty from April’s tariff announcement, which had widened spreads earlier in the year. However, by July, a 90-day tariff pause and easing trade tensions helped stabilize markets. Spreads tightened sharply from mid-April highs near 120bps, returning to historically low levels. The Bloomberg US Aggregate Corporate Average Option-Adjusted Spread narrowed by 9bps during Q3, ending at 74bps — the tightest level seen since 1998.

Customer demand for credit was robust during Q4, while a mix of buyers — including insurance, money managers, private wealth, foreign investors, taxable bond funds and Exchange-Traded Funds (ETFs) — supported strong market technicals. Lack luster new issue supply in July and August (roughly $121 billion) was the summer’s driving force behind spread compression and positive market technicals. September flipped the script, pricing a record for that month of $226 billion, however supply was easily absorbed by customers looking to add duration in Q3 — with many accounts selling bonds three years and shorter to buy 10 years and longer, causing credit curves to compress.

Tax-Exempt Fixed Income[**]

After a difficult start to the year, Tax Exempt municipals have performed well over the last six months, especially the last quarter. Although the tax-exempt fixed income space continues to be dominated by the prospect of another record supply year, we have seen continued inflows from both the mutual fund and ETF space. Supply is currently running up about 8% year-over-year with the weekly average supply number at over 12 billion. At this pace, there is a chance we get close to $575 billion versus the $525 billion in issuance from 2024. 

Municipal market technicals remained favorable in October, supported by steady inflows, moderating supply and reinvestment demand. Issuance topped $50 billion but was absorbed efficiently, while fund flows extended a 10-week streak of positive momentum, reinforcing strong liquidity.

Ratios have improved steadily after widening earlier this year, now sitting at 65% of Treasuries in the 5-year range, 67% in the 10-year, and 90% in the 30-year — reflecting stronger tax-exempt performance versus last quarter. The municipal yield curve has flattened recently, with short maturities cheapening slightly while the long end outperformed. Investors appear more comfortable with overall yield levels and have been extending duration to lock in historically attractive nominal yields. 

Key trends include strong credit fundamentals, sustained demand for higher education and infrastructure financings, and strategic portfolio positioning. Many investors are favoring barbell structures and short-call bonds to capture roll-down and carry benefits, aligning with expectations for further Fed easing.

December and January are typically better performing months for fixed income due to reinvestment money, but the prolonged government shutdown has limited key economic data, making it harder to gauge growth, inflation, and Fed policy. Investors are expected to focus on corporate earnings for signs of shifting credit fundamentals, while renewed Merger & Acquisition (M&A)  activity and large bond deals could add year-end supply pressure. Geopolitical and trade headlines remain in play but had little impact on risk assets in Q3 — still, they warrant close monitoring to avoid surprises.

Interest Rate Derivatives[***]

After holding rates steady for much of 2025, the Fed’s three recent cuts bring the target range to 3.50-3.75%, prior to inflation reaching the Fed’s target level of 2% and was geared more towards the slowing labor market, posting only 100,000 new jobs in the second half of the year.

Expectations for further Fed rate cuts in 2026 have eased, as strong consumer spending and inflation holding near 3% suggest a more cautious stance. The dot plot from the Fed’s December meeting implies roughly one to two more cuts in 2026.  With the individual participant projections split between 3.75% and 3%, the potential path forward is relatively uncertain as the Fed awaits incoming data with respect to job growth and inflation.

Swap spreads—the difference between SOFR swap rates and U.S. Treasury yields—have widened sharply since early September, moving 12–15bps on the long end versus typical quarterly shifts of just 2–3bps. This unexpected move has sparked debate over the drivers, with potential factors including lower anticipated Treasury supply, stronger demand, hedge fund positioning, the end of Fed Quantitative Tightening (QT), and evolving bank regulations.

Looking ahead, spreads may continue their march wider, although at a smaller pace, as short-side positioning at elevated levels provides some near-term containment. Markets remain focused on how tariff changes and continued uncertainty may influence the broader economy going forward. 

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