The two most decisive and return-relevant dimensions that a fixed income investor is constantly trying to optimise are duration and credit risk. Typically, exposure to these two factors is negatively correlated, even if more recent developments suggest differently. By the end of 2025, we expect the absolute yield level, i.e. the relevant measure in terms of duration, to be at similar or slightly higher levels overall, but with some sizeable swings during the year as actual US policy is revealed. Meanwhile, we assume credit spreads, i.e. the relevant measure for credit risk exposure, to remain relatively tight and comparatively less volatile, even if slightly higher than current levels. Below we take a closer look at fixed income in the different geographical markets.
US: Somewhat braver in terms of credit risks
As the new US administration takes over the wheel early next year, the US, and consequently also the global economy, will be shaped by the actual policy implementation. There have been many campaign promises as well as threats. Our working assumption is that the US growth-enhancing elements, i.e. deregulation and a favourable tax regime, will prevail, while potential negative growth effects through adverse trade policy will be limited to a certain extent. Obviously, this assumption is the decisive as well as the controversial one. In such an environment, the US economy will continue to benefit from solid activity, ranging from investments to private consumption.
There is a low risk of the Fed being behind the curve
In the US, monetary policy is still in restrictive territory and officials are likely to continue the easing cycle, as their current assessment is of a balanced risk between inflation and a slowdown in the economy. As such, there is a possibility of private sector balance sheets releveraging, which would eventually add to the return of inflationary pressures. With this in mind, the chance of the Fed ‘being behind the curve’, i.e. not cutting fast enough and thereby substantially damaging the economy, is remote. In fact, the Fed has less room to cut now and could rather risk being too fast next year, triggering a new credit cycle. All in all, the policy combination for next year suggests that longer-term yields are unlikely to fall very quickly.
Corporate credit is the segment that is going to benefit from this set up. The low probability of the Fed being behind the curve simply means that nominal growth will be high enough to absorb the higher refinancing costs. As a consequence, we not only expect the default rate to move lower next year – which is the broad consensus here – but we also assume that the default outlook will remain favourable.
EU: More room and urgency for cuts in the eurozone
The situation in the eurozone is quite different from that in the US. In fact, the underperformance has been going on for some time, and not just in current economic activity. With consumer confidence still shaky, the outlook also does not look any different from what was seen in 2024.
As a result, there is much more room – or necessity – for the European Central Bank (ECB) to cut rates towards neutral and below in 2025. The Governing Council of the ECB switched gears in the last quarter of 2024 and accelerated the cutting cycle. However, it does not appear that policymakers feel the urgency to really opt for an accommodative monetary policy stance, despite the lacklustre economic environment. As such, we believe there is a higher risk that the ECB might find itself behind the curve and need to cut even faster down the road.
Lag of political leadership does not help
In addition to the economic challenges, political turmoil is an additional headwind. We see periphery governments, e.g. Spain, Portugal, or Italy, well positioned to navigate through 2025; economic outperformance is set to continue and the fiscal outlook for the still highly indebted countries is set to improve for a change.
Switzerland: Back to the question of ‘negative’
The big question in the CHF market is whether the Swiss National Bank (SNB) is already destined to slash rates below zero in 2025. Admittedly, inflation is very low in Switzerland and the SNB’s own inflation forecast also signals more easing to come. Moreover, the central bank does not welcome further Swiss franc appreciation at this point. As such, it might well be that we hit the zero line next year already. The SNB has left the door open for a return to negative territory, but we do not think there is much appetite to do so too soon.
There is a good chance that Swiss franc strength can continue. Moreover, the currency benefits from a safe-haven status and unmatched price stability, and proves its store of value characteristics when things turn sour and do not go as expected. In such a scenario, investors gain on the currency and additionally on capital gains as yields move broadly lower.
Emerging markets: Bumpy path to rate normalisation in Asia
Asian economies navigated a 2024 that saw a relatively subdued macroeconomic and credit backdrop even as China continued to grapple with economic weakness amid poor demand and a property sector that is struggling to recover. For a large part of the year, most Asian central banks were riding on the coattails of economic growth recovery, inflation moving to their target ranges, strong local-currency funding conditions and a more balanced tone from the Fed over its rate trajectory.
Heading into 2025, we are faced with a different macroeconomic backdrop along with stretched credit valuations. The biggest risk facing Asian economies is the impact of US tariffs that will be levied by the US on Asia, especially China. China is now the biggest trading partner of most Asian countries including Japan, South Korea, Singapore, Malaysia, Thailand, and Australia. If trade tensions escalate into a trade war, Asian countries will be forced to trim growth forecasts. Slowing GDP growth could weigh on Asia-Pacific corporate earnings. Asian countries have been pushing back on rate cuts even though inflation remains well contained.
What does this mean for investors?
As we move into 2025, we need to keep an eye on i) how the new US administration’s policies will actually be implemented , ii) whether any major central banks are behind the curve or too far ahead of it, and iii) related to this, how a potential re-leveraging of private balance sheets is evolving. Depending on these developments, it may be necessary to adjust the strategy accordingly – but this will be a decision to be taken during 2025.
As rate volatility will be high again in 2025, a tactical approach is warranted. All else being equal, yields that rise quickly offer opportunities to add duration and lock them in for a longer period, while yields that fall significantly further from current levels should be used to materialise some capital gains and reduce duration exposure. Moreover, corporate credit should remain the core building block, and we expect the segment to continue to outperform government debt, even if valuations are not cheap.