2025 Outlook: A Balancing Act
A new US administration, unsustainable fiscal dynamics, and stretched risk market valuations, in a challenging global backdrop, requires a balancing act to deal with the uncertainty & volatility ahead…
Our title suggests that the year-ahead will be a balancing act, one that will likely come with heightened uncertainty and increased vol. Such a path does not need to be a lasting painful experience, but there could be some short-term pain that leads to long-term gains.
Macro
- Baseline Economic Scenario: The economy has been performing well but is dependent on government spending and the wealth effect to continue to deliver strong growth ahead. Meanwhile, a major jobs data revision to be released in February may clear the air on the true health of the labor market, which we believe is weaker than the NFP jobs report suggests. Any reduced pace in job growth (or actual job losses) along with a focus on fiscal consolidation could mean a further deceleration in economic activity (which is disinflationary). This plus increased energy production can keep inflation at bay. Further afield we should eventually experience benefits from deregulations and other technological efficiencies (leading to a more sustainable growth cycle in the medium-term).
- A hard balancing act ahead: Of course, there is a risk that the incoming administration throws caution to the fiscal winds and markets push back (via higher long-term rates). Meanwhile, a lot of the good news on future growth is likely already priced-in to markets while bad news (tariff risks etc.) isn’t. It's also possible some elements of the US economy already felt recessionary forces and now recover.
- Fed Forecast: We view the first 100bps in cuts as a down payment on a rates normalization process. That said, the next 100bps of cuts (if fully delivered) will likely be drawn out. For now, the Fed should continue to move towards the long-run neutral rate of ~3%. At a minimum we expect the Fed to only cut rates at SEP quarterly meetings (March, June and September) with the risk of a longer pause in 1H25. We also expect the Fed to end QT and start a full UST tapering and shift MBS proceeds into auction add-ons later in the year.
Markets
- Rates Forecast: We expect the curve (ex 2Y) to remain above 4% in 2025, though a longer Fed pause would add upside risk to our 2-year forecast. The best risk-reward is to remain with front-end longs or steepeners and be underweight 10s, especially if we were to rally at some point in 2025. Overall, a hawkish Fed, fiscal policy uncertainty, and more supply should keep 10Y yields higher in 2025.
- Credit Spreads: The base case is for IG and HY to widen modestly in 2025. That said we expect IG spreads to test the wides briefly touched this past year. US HY credit has much better fundamentals at this stage of the business cycle (versus prior ones). However, HY is still a risk product and could be subject to external shocks coming from an abrupt and acute tightening of financial conditions.
- Mortgage Spreads: Current coupon MBS spreads have remained historically wide lately. To break out of the range to new tighter levels, markets need a new source of demand (outside of just real money), as well as lower funding costs and curtailed rate volatility.
Please download the PDF (see link above) for the full outlook report with chart studies and our fixed income forecasts on page 18-22…
