Fixed Income Investment Outlook
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After several years of fixed income markets driven largely by central bank policy, attention will likely focus more this year on fiscal actions—policy and revenue decisions by the new Trump administration as well as those other governments reorienting their priorities or beset by financial strains.
Ever since COVID-19, investors have focused largely on central banks for clues as to fixed income performance, from instituting zero-rate policy and financial liquidity to maintain the global economy during the pandemic, to tightening to offset the inflation surge of 2021 and 2022, to the widely anticipated start of the current easing cycle. With inflation continuing to recede, we are moving into a period of gradual central bank rate reductions.
The U.S. stands out for its relatively robust growth, which we believe could surprise modestly to the upside this year. However, slow progress on inflation may limit the Federal Reserve’s capacity to cut interest rates further. Europe appears more vulnerable to a stilted export environment, particularly to China, but with more wriggle room for easing. At the same time, anxiety is growing around the long-term fiscal picture in the U.S. and select other countries, which could pressure longer-term rates and help steepen the yield curve. Given the upward adjustment in longer yields late last year, the chances of further rate shocks appear limited. However, we remain relatively cautious on duration, seeing opportunities for trading more at the shorter end of the curve.
In the credit market, all-in yields remain robust, but spreads are exceptionally narrow, with few areas displaying the obvious dislocations seen a year ago. This limits the value of credit exposure overall while reinforcing the benefits of identifying value to maximize carry. Floating rate loans and some segments of the emerging markets universe, among others, currently meet this criterion.
In some ways, the coming year may prove trickier for investors than 2024, as the past high-conviction idea of lower central bank rates has been displaced by political dynamics and questions around the longer-term course of government budgets and interest rates. In the U.S., looming policy shifts, including potential changes to taxes and the use of tariffs, could heighten market volatility and will likely be an ongoing consideration throughout 2025.
Our key market and investment themes appear below the following pages.
The U.S. has consistently outpaced growth expectations in recent years, and while few believe that the country will experience recession, some anticipate downside risk to forecasts from here. In contrast, we believe that U.S. growth could actually surprise on the upside with continued momentum in the low 2% range. This would largely be driven by the consumer, who we believe will likely increase spending on durable goods, while services should remain steady. We anticipate softening gross domestic fixed investment near term, while net exports and government expenditures should slow.
In the eurozone, although consumption represents more than half of regional GDP, exports and government spending also play a major role. Although demand has recovered somewhat recently, it remains largely dependent on the U.S. amid China weakness, and therefore vulnerable to trade actions. Meanwhile, government spending is currently north of 5% of GDP, which may be difficult to maintain.
The year is likely to be a period of continued progress on inflation, which points the way to further reductions in policy rates. In the U.S., we see inflation remaining above target throughout the year, leading to just two cuts in 2025, with an additional reduction in each of 2026 and 2027 for an ultimate neutral rate of around 3.5%. Overall, we feel current growth, inflation and policy prospects lead to fair value for the 10-year U.S. Treasury of a range around 4.5%, or somewhat below recent trading levels.
In Europe, there are fewer obstacles to inflation normalization. Export weakness, coupled with the danger of renewed trade tensions with the U.S., provides more scope for reductions this year, with a neutral rate of about 1.75% achieved by July.
For the past few years, all eyes have been on central banks and policy shifts: first, decreases to combat COVID-related weakness, then hikes to counter runaway inflation tied to supply chains and excess stimulus, and more recently, in the anticipated pullback of tightening. However, fiscal issues are now looming far larger. In the U.S., Republicans are focused on extending provisions within the Tax Cuts and Jobs Act of 2017, while considering new proposals like eliminating taxes on tips and Social Security income, and introducing tariffs, which, depending on their scope, could prove inflationary.
In the meantime, various other countries are facing fiscal stresses and higher borrowing costs. For example, proposed belt-tightening in Brazil was dismissed by markets as too limited, causing an increase in the country’s interest rates. France has also been struggling to contain spending and, after Germany announced flash elections, bunds traded wide of their swaps for the first time in history.
Last year, corporate credit spreads were relatively tight on the back of sturdy economic and business fundamentals. However, there were pockets of dislocation in spread sectors such as in agency mortgage-backed securities, with mispricing based on technical issues or misunderstanding of market risks.
Today, however, we see few segments with such widespread anomalies, as reflected in the comparison of yields and option-adjusted spreads shown below. In general, fundamentals continue to justify narrow spreads, although we are seeing some deterioration around the edges. More broadly, with fewer obvious choices for capital, we favor a more incremental view of seeking to maximizing carry across a range of assets, without heavy bets on particular areas.
Despite broadly narrow credit spreads, some areas continue to provide appealing relative value. These include collateralized loan obligations (below) and hybrid securities, which continue to offer a yield advantage over other fixed income assets of comparable credit quality. Although emerging markets face headwinds over the strong dollar and elevated U.S. rates, we see pockets of opportunity, including in non-investment grade corporates, where default rates are easing (also below); in particular, Latin American high yield offers option-adjusted spread of about 100 basis points over U.S. counterparts, roughly in line with its historical average.
2 Generic 7-year U.S. Treasury Yield.
3 Source: Bloomberg, JP Morgan and S&P/LSTA Leveraged Loan Index as of December 31, 2024. Data shown represents CLO yield to maturity bond yield to worst. Benchmarks used were the BofA Corporate Bond Indices and JP Morgan CLO Index. Hedge Benefit to USD is 1.61%, based on annualized benefit of a 3M USD/EUR Forward. You cannot invest directly in an index. Excludes defaulted issuers.
4 Source: Bloomberg, JP Morgan and S&P/LSTA Leveraged Loan Index as of December 31, 2024. Data shown represents CLO yield to maturity bond yield to worst. Benchmarks used were the BofA Corporate Bond Indices and JP Morgan CLO Index.
2024 was a time of historic elections affecting over 70 countries. Whether the Labour victory in Britain, electoral gains by the far left and right in France or legislative losses by India’s ruling party, the stories together painted a picture of populist shifts and a willingness to cast out incumbents to foment change. Among all the contests, few were as significant as Donald Trump’s victory in the U.S., with the potential for impacts across the country’s regulatory environment, tax structure and trade, as well as globally.
We will be considering all of these trends as the year progresses, assessing impacts on inflation, rates, geographies and issuers. In our view, it seems likely that the policy environment will be eventful in the coming year and beyond—potentially generating price volatility, but also opening up opportunities for those with the ability and desire to capitalize through the timely use of capital.
*Currency views are based on spot rates, including carry.