Fixed-Income Outlook 2025: Opportunity and Uncertainty

The Global Outlook

From a global perspective, there are mixed signals for the economic outlook. Recent activity data such as purchasing managers’ indexes (PMIs) indicate contraction in Europe, Asia and some emerging-market countries. The US, however, has been an exception to this, with a more positive outlook, at least for the time being. The key question is whether this growth momentum will extend beyond the US.

Given its more promising short-term outlook, there is a divergence between the US and the rest of the world in terms of interest rates, currency performance and equity markets. This divergence may persist into the first quarter of 2025, but beyond that, uncertainty prevails, and some recoupling may be possible in the second half of the year.

The policy agenda of President-elect Donald Trump’s new US administration could have major implications. Policies focused on curbing immigration and imposing tariffs could hinder growth and increase inflation. Conversely, deregulation and potential tax cuts could boost growth. There is also discussion about improving government efficiency, reducing red tape, and cutting some expenditure programs to control the budget deficit. The incoming administration will not be in place until January 20, 2025, and some policies may be implemented while others may be scaled back.

Interest-rate expectations in the US have been revised in line with growth and the election outcome. In other regions, interest-rate expectations are declining given weaker growth. The US Federal Reserve (Fed) is expected to be cautious in 2025, balancing inflationary pressures and growth uncertainties.

The US dollar’s strength, driven by recent appreciation, may face challenges as the new administration aims to boost US manufacturing competitiveness, which would require a shift in policy on the dollar. If the US dollar is part of the policy toolkit for the incoming administration, we should pay attention to how it approaches policies to weaken the dollar, as they could create volatility in markets. If successful, we could see a reversal in dollar strength in the second quarter and later into the year.

One aspect that we think is worth monitoring is the term premium (the excess return that investors demand to hold a longer-term bond instead of investing in shorter-term securities), which reflects investors’ fiscal concerns. There has been some build-up in 2024, but it has come with a re-steepening of the US yield curve. At this juncture, we are not unduly concerned, but we remain vigilant.

Inflation and Interest Rates

We believe the neutral interest rate (the level at which economic activity is neither stimulated nor restrained) in the US is currently somewhere between 3.5% and 4%, which seems to be already priced in by the market. The surprise element is what will matter – whether the economy stays strong beyond the first quarter of 2025. For rates to fall significantly below 4%, we believe growth would need to surprise to the downside.

In terms of inflation, the core components remain sticky, which is why we think the Fed is likely to adopt a cautious policy. If the growth elements of the new administration’s policy agenda do not turn out to be as supportive as expected, the Fed could engage in further rate cuts. We need to be wary in understanding which factors will have more weight – whether it is the tax and deregulation agenda, or immigration and tariffs. Tariffs could come sooner and hit sentiment, being more painful for countries in Asia and Europe. Deregulation and migration would take some time to be reflected in company earnings and inflation. The net risks to inflation are higher, but the macro backdrop remains unclear, so we caution against drawing major conclusions.

For these reasons, we need to monitor the term premium in the bond markets. A lot of what could occur is fiscally expansive and puts upward risks on inflation in the US. Could such developments rile bond markets so that this fiscal term premium emerges? The US is a prime candidate for bond vigilantes.

The US is a prime candidate for bond vigilantes.

Weakening of the US Dollar?

As dynamic investors with a long-term view of markets, we think the most interesting aspect is the policy which aims to reindustrialize the US. The ‘America First’ policy has major implications for the currency setup. While some incoming administration officials have suggested efforts to weaken the US dollar – and whether the administration actively pursues such measures remains to be seen – this does not guarantee that the currency will weaken significantly. The market’s response so far has suggested stickier rates, more persistent inflation and higher growth in the US, which is likely to lead to a rising dollar. This theme could continue, but we must be cautious as a stronger US dollar could undercut Trump’s stated policies to boost US manufacturing competitiveness.

The dollar’s trajectory is likely to be influenced by negotiations between the US and China, Europe, and other emerging-market economies which are trading partners. We believe there is a multi-year risk of the dollar’s strength reversing, leading to a weaker dollar over the long term.

Geopolitics at Play

China is seen not only as a trading partner for the US, but also as a rival in the technology sector, as well as economically. This divergence in relationships may persist. Since 2018, when the last set of tariffs was imposed, China has been increasing its efforts to move away from its current account surplus with the US. We have seen this in the country’s transition from low-cost manufacturing to higher-end manufacturing of goods such as electric vehicles. We expect this trend to continue.

Europe, traditionally seen as a partner to the US, is in a tough spot owing to its economic exposure to China. The euro has weakened, and Europe faces a choice between US tariffs and its own tariffs on Chinese electric vehicles. Europe might need to offer something in return for defense protection, possibly increasing investment in the US or accepting appreciation of the euro. There might be scope for the US to negotiate with Europe, but China is a different story.

Opportunities for 2025

From a contrarian perspective, we think the US dollar’s future could be interesting. We believe an intriguing possibility is that foreign assets could outperform US assets in 2025. The euro and European assets look particularly interesting to us, as do emerging-market currencies and local rates.

In the short term, there is likely to be more pressure on the currencies, bond markets and equity markets of emerging-market economies. However, we believe there is a once-in-a-decade opportunity to buy attractively priced assets in many emerging economies, although this is predicated on the strength of the US dollar over the short term. If dollar strength does materialize, we think the most appealing assets could be in emerging markets as well as in Europe, where the market is currently pricing in a lot of pessimism. In this scenario, there could be capital outflows from the US. 

We believe there is a once-in-a-decade opportunity to buy attractively priced assets in many emerging economies, although this is predicated on the strength of the US dollar over the short term.

There is also the possibility that Europe could react under pressure. There has been more discussion around the Draghi report, which is a very detailed plan on how to deal with competitiveness and most of the major stumbling blocks that Europe faces. Should the Draghi plan receive more attention, we could see a multi-year period of investment in which Europe invests as much as 5% of GDP to repair its framework, which is still incomplete. This would be very bullish for European assets, but it is not a given.

Authors

Ella Hoxha

Head of Fixed Income