Fixed income markets face key questions that will shape their direction in the year ahead. Could the disinflationary trend of recent years reverse, bringing renewed concerns about inflation? Will valuations in areas like corporate bonds and credit spreads start to play a bigger role in investment decisions? And how might anticipated Republican tax cuts drive an increase in Treasury issuance, affecting supply and demand dynamics? These issues will influence bond market trends and investment strategies in the coming months. This post explores these questions and their potential impact on fixed income.
Will the disinflationary trend reverse?
Inflation’s steady decline since it peaked in mid-2022 has allowed the Federal Reserve to shift its policy stance. Following the end of rate hikes in July 2023, the Fed began lowering interest rates, with a 50-basis-point cut in September 2024, another 25 bps cut in November, and a 25 bps cut anticipated at the December meeting. The US economy is currently supported by a moderate economic expansion, strong consumer spending, easing monetary policy, and a fiscal deficit nearing 6% of GDP. While this growth and policy mix has supported expansion, the risk of inflation remains a potential disruptor, which could spur the Fed to pause interest rate cuts or even raise them – although the bar remains high for rate hikes.
Our base case is that disinflation will continue. Price increases typically slow gradually, with global energy supply pressures helping to lower energy prices and shelter costs continuing to ease. Shelter inflation, the largest component of core CPI, typically moves steadily, and private sector rent data points to continued disinflation in that component.
While tariffs and tax cuts could add inflationary pressures, it will take time for these policies to take shape and influence the economy. Inflation was a key issue during the last presidential election, highlighting its importance to voters. This should make the incoming government especially sensitive to inflationary concerns.
Will valuations start to matter?
Investment grade corporate spreads are currently below 80 bps, and high yield spreads are at 261 bps, both of which represent multi-decade lows. Despite these historically tight spreads, investors continue to be drawn to these sectors for their attractive all-in yield. Meanwhile, the mortgage-backed securities (MBS) market is seeing current coupon spreads at 130 bps, a sharp contrast as these spreads sit at long-term highs. This disconnect highlights an interesting dynamic in the market, where some areas are offering tighter spreads, reflecting little compensation for credit risk, while others present interesting relative value opportunities.
Meanwhile, the VIX remains low near 13, and equity markets continue to hit new highs, fueled by expectations of a growth-friendly policy mix that drives valuations higher. With these conditions in mind, a key question for 2025 is whether the market will start to pay more attention to valuations, both on a relative and absolute basis. As risk assets continue to rally, the persistent low volatility and tight spreads may give way to concerns over overvaluation, especially if inflation or ebullient sentiment starts to fade. Investors will need to assess whether the current levels are sustainable or if the market may soon recalibrate.
Do anticipated tax cuts lead to higher Treasury issuance and higher long-term interest rates?
The Republican sweep during the 2024 presidential elections should give way to an extension of the Tax Cuts and Jobs Act (TCJA) and the possibility of additional measures. Tax cuts are expected to stimulate economic growth by increasing disposable income for consumers and boosting investment for businesses, leading to higher demand and job creation. However, it could also lead to higher Treasury bond issuance because tax cuts often reduce government revenue without a corresponding decrease in spending, widening the budget deficit. To finance this shortfall, the government issues more Treasury bonds, borrowing from investors to cover the gap between its expenditures and revenues, which could result in rising longer-term interest rates.
Interestingly, while long-term yields rose going into election day, they have fallen steadily since then, despite a Red Sweep. This likely reflects investor optimism about potential fiscal restraint, as signified by the formation of the Department of Government Efficiency (DOGE) and the nomination of Scott Bessent as Treasury Secretary, a credible market practitioner who recognizes the risks of fiscal expansion on long-term interest rates and the real economy. While we are hopeful that the new administration will be more sensitive to the growing deficit than initially anticipated, it's still early days.
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