Fixed Income Moves in 2025

Fixed Income Moves in 2025

Anu Rajakumar: With the new US administration at the helm, investors around the world are eagerly preparing for what is to come regarding domestic policy, international policy, tariffs, and geopolitics. How will fixed-income strategies navigate this new pathway? What factors are at play regarding fiscal policy, and how can investors prepare for the year ahead? My name is Anu Rajakumar, and joining me today is Ashok Bhatia, chief investment officer and global head of fixed income, who's here to guide us through these intricate dynamics and share his insights on the asset class. Ashok, thanks for joining me today.

Ashok Bhatia: Thanks, Anu. It's good to be back.

Anu: Ashok, in the Q1, 2025 fixed income outlook that your team published and also in our Solving for 2025 market outlook publication, you predicted an important shift for bond investors this year, essentially going from being intense Fed watchers with a focus on monetary policy to instead focusing more on fiscal policy going forward. Could you begin by recapping that for us and talk about why you think this is an important shift?

Ashok: Yes. I think if you take a bit of a step back for the bond markets, the last two to three years, really since the end of the COVID crisis, we've all been very focused correctly on what the Fed is going to do. First, the Fed had a hiking cycle, and then the Fed has had, in the process, an easing cycle. The dynamics and what's impacted bonds and bond valuations and curve shape, it's largely been driven by the Fed in getting that path of tightening and easing correct.

The big shift for this year is our view, as you mentioned in our quarterly, we make the point, the Fed's probably still easing this year. I think right now as we record this today, the bond market and bond market participants feel like the Fed might just be on hold or even hike. We're in the camp the Fed will ease again this year, probably twice, maybe once. The shift is really that the Fed is going to recede to the background.

One ease, two eases, the Fed's going to be at a spot where we think they can hold rates for an extended period of time. At the same time, the fiscal dynamics are suddenly increasing pretty quickly. Just for a bond investor, last year and the second half of last year was particularly interesting as budget deficit concerns started surfacing France, the UK, emerging markets, and then obviously a discussion on this in the US.

We break what the fiscal policies that are coming, and part of it is just trends, but part of it is the new administration, is that there's really three big elements of what fiscal policy is going to matter for the bond market. One is the policies around tariffs, what will be the inflation impact of that, whether it be a growth impact, but call it tariff policy. The second will be immigration policy, and what does that mean? That can have impacts both on growth and inflation as well. Then the third big bucket is the budget, and what will be this administration's priorities around taxing and spending and how that will impact.

You can pull in deregulation here, what that will mean for potential growth for the US for the coming years, as well as the impacts on growth and inflation as well. We're going to this environment where the bond market and it's ultimately the economic variables that drive where bond yields go. The impact is coming from the fiscal side and just a lot less from the monetary side. It's going to be an interesting year and, frankly, a trickier year to navigate, I think, for the bond markets.

Anu: Terrific. You mentioned the impact on inflation and growth and how these various policies are going to affect those. Let's talk about inflation for a second. You've identified in these publications that you expect inflation to soften in 2025. What's going to drive that, and how does that expectation line up with, as you mentioned, some of the policies of the new administration that may contribute to inflation going up? Again, you mentioned tariffs, and immigration limits as well?

Ashok: On inflation, our view is core inflation in the US is roughly around 3.2% year over year, last 12 months. We think core inflation over the course of 2025 will decline to something around 2.5% to 2.6%. That may sound only like half a percent, but that's a meaningful fall that moves you closer to the Fed's targets for where they ultimately would like core inflation to get to.

We do think this is a year that will be a continued year of disinflation and this year a little bit more driven by just ongoing softening in the housing markets. That's not that house prices are going to start going down but a little bit more stability or smaller increases in houses and rents. Importantly, we think also the labor market is coming back into a little bit better balance that will result in a little bit lower wage gains. People will still see wage gains but a little less, and that's less inflation impetus into the economy.

Our view and I do think with where we sit in the markets today, that's a little bit out of consensus to view that this is a year of disinflation again. Then, Anu, as you mentioned we have these policies that can be coming in. Tariffs, a lot of it obviously will depend upon the exact policies. Our base case is some tariffs, phased-in tariffs, maybe a bit more of a negotiating stance, at the end of the day.

Something that can raise inflation rates this year by two-tenths, maybe three-tenths, it can change the amount of disinflation we have, but it doesn't change this from a disinflationary to an inflationary year. We struggle to see how tariffs could result in that kind of a dramatic shift. Similarly, you mentioned immigration, and this is a much trickier issue, I think, to disentangle all the economic impacts.

At the end of the day, our view is that if we're obviously-- and it's already happened that legal and illegal immigration into the US right now is falling, but the deportation policies, what we get there and really how much is this going to touch the workforce or is this going to be in the people in jails, criminals, those types of things, people that probably aren't in the workforce, that's a bigger issue. On that, we see, actually, bigger growth impacts from that, depending on how extensive it is, than inflation impacts. At the end of the day, we're not seeing anything that can change, dramatically, the inflation picture for this year right now.

Anu: Sure. Maybe transitioning to the growth picture, the new administration's policies are expected to be fairly pro-growth and pro-US. Maybe talk a little about what you think those drivers of growth will be, and is it the consumer, is it elsewhere? Also, do you think that the US is going to lead other developed market economies?

Ashok: Yes. Those are some great questions. I think on the growth impact, we can have animal spirits. We'll have some deregulation, but the way we're thinking about this is it's unlikely to move the needle an awful lot on growth in 2025, right? A lot of these policies are more aimed at increasing trend and increasing productivity growth for the US, and those are things that will just take longer.

We're unlikely to get even a budget agreement until the spring at this point, much less when it gets implemented, and the tax regime and tax cut regime probably not changing this year or next year. I would say, think about the growth impact of these policies as more being 2026, '27 events. As you said, I think the base case should be that these are going to be policies that are aimed and likely would increase trend-US growth in those outer years.

As for pulling on the rest of the world, our bias here is that the US is still the largest economy. We are largely still, I think it surprises people, more of a closed economy where our tradable sector and exports and imports still are a relatively small part of our economy, compared to a lot of other places. The US will have growth spillovers if we do well. It'll naturally drag up places like Mexico and Canada, but for the rest of the world, for example, Europe growing faster, China growing faster, those end up influencing a lot more countries than the US picking up a little bit more growth.

Anu: Sure. Well, thank you for sharing the macro views. You've put a good backdrop here. Now let's talk about all this means in terms of areas of opportunity and risk within fixed-income markets. Where should investors look, given spreads that are tight in credit, and other areas might be challenging? Where are the opportunities?

Ashok: Well, I'll just start with the first basic, like is this going to be a good year for fixed income? I recognize the bias of being a fixed-income person, but I will say I think the setup for this year, and it's surprising maybe, but it's a much better setup for bonds and bond returns this year than last year was. If you go back to last year, and I think it's this question of, "Hey, the Fed eased 100 basis points last year. If you look at the broad bond market indices, they were up 1% to 1.5%."

I think intuitively you would think, "Hey, if the Fed eased 100 basis points, bonds should have had a really strong year," and they didn't. If you disentangle why, it was really two things. It was first, yes, the Fed eased 100 basis points, but the market was expecting them to ease 150. The bond market or the Fed underdelivered to what the bond market had priced for the start of 2024.

The second issue for the bond market was 2024 started the year with a 10-year treasury rate sub 4%. We ended up going almost up to 5% last year.

We also started the year with very low long-term yields. Some of the things we're talking about today on deficits and debt, those weren't really on the market's radar screen. But you flip through to today, and I think there are a couple of key differences for the bond market that make us more optimistic.

One is, the bond market's really only priced for the Fed to ease one and a half times this year. The hurdle rate's pretty low. You don't need the Fed to do an awful lot for bond yields to be, in our view, supported around these levels. The second issue is that these deficit concerns, they're more in the price. With where long-term yields sit, we would argue that the bond market is equally exposed to bad news on the deficit as it is to good news.

Imagine a world where in March we get a budget deal that says, "Hey, the bond market conclusion is deficit may be not be coming down, but it's not getting any worse, and there's the proverbial light at the end of the tunnel." We would think that's going to be a positive event for long-term bonds as well. The third and perhaps maybe even the biggest issue is just the income dynamics, the policy rate, for anyone listening that maybe has savings accounts or bank accounts or money market accounts, your yield on those is going to be plus or minus, it's going to be around 4%.

It's no longer five and three-eighths, which is where the policy rate was a year ago. The cash rate is lower, and suddenly a lot of these government bonds and yields yield more than that. There's positive income available from moving out of cash. That's a dynamic we also think will support fixed income, is that as people look and say, "Hey, I can pick up 50, 100, 150 basis points by doing some maturity extension," that helps fixed income.

I forgot what your exact question was to start this, but I do think the outlook for fixed income this year, I think we're building a pretty strong base from where the rates market sit. Then you did ask about credit spreads, and you're absolutely right. Credit spreads are tight. They're low. The amount of extra income or yield you get for high yield or investment grade credit, however you slice it, these are the low ends, very low ends of historical ranges.

Our view here is just don't expect a lot of fireworks. Credit spreads last year were pretty range-bound. They weren't that volatile. It was because fundamentals remained strong. The environment that we think happens this year of lower inflation, decent growth, Fed easing a little bit, it's hard to see that disrupting spreads a lot. I think investors should approach this year thinking there's a little bit of downside in bond yields, and credit spreads broadly are going to be stable. You can pick up a little bit extra income there. Spreads probably stay on the tight side.

Anu: Great. Well, you did answer my question perfectly, so thank you for that. Maybe just dig into a little bit more, are there any fixed-income strategies or approaches that you think would be particularly effective at generating alpha? For example, how are you thinking about duration management for 2025?

Ashok: Yes, I think this could be probably its own podcast, but I think if I take fixed income and I've been doing fixed income for about 30-plus years now, and the bond market's gone through iterations. There was an iteration where you could even go back to the 1980s, where the interest rate moves were these very large, powerful moves that drove a lot of the total return profile for bonds.

Then we went through a period, and it's really since the financial crisis when central banks pinned policy rates at zero and did a lot of bond buying. When we got this macro volatility, some macro events, and there's obviously been a ton since 2008 where there were two events where "Will the European Union survive?" energy crises, et cetera. This all ended up being, the volatility was expressed in credit spreads.

It wasn't really expressed in interest rates because interest rates were at zero and couldn't go anywhere. The world we've shifted into now is that this macro volatility, so these debates about growth and inflation, they now are coming back into the bond market. They're not going into the credit markets. If you just look at last year, range-bound credit spreads but interest rates go all over the place and hundreds of basis points of ranges.

For a bond investor, one thing I think to keep in mind is that if you have a 50-basis-point move in interest rates, and a 50-basis-point move in credit spread, for close enough for government work, those are equivalent total returns or excess returns. If you can capture one and not the other, it leads to the same or substantially the same result for a client or any investor.

I do think the bond market is in this world, and I think it's going to persist for a while where the volatility is in interest rates, but the change that's going to happen now is a bit more divergence between bond markets. The bigs up and big down moves that have generally been highly correlated, I think you're going to start to see the start of a lot more dispersion on that, and it's going to be important, whether it's us or anyone else operating and investing in fixed income, capturing the moves of interest rates. If the objective, whether it's total return or alpha excess returns, it's rising very rapidly as a necessity I think for professional fixed-income asset management.

Anu: Yes, that's great. Now, thanks for sharing those thoughts about managing volatility and portfolios. You painted a picture, generally, I think of optimism for fixed-income markets. What are some of the risks to that view? Maybe also just speak to the strength of the dollar as one element that might be a factor here, too.

Ashok: Yes. It's great to come back to that and for our views, and I think you want to start, obviously, with the recognition that we can be wrong about things, for sure. I think one area is like if we are very wrong on the inflation front, that if we are missing something, I think if there's something we're really missing, it would be more along the lines of the housing market, and we're over-optimistic about house prices and the inflation that's coming out of the housing system.

If we're wrong and this is a year of inflation, it could be the tariffs. It could be something else that changed that dramatically, but say an environment where the Fed felt the need to hike, that would be very disruptive for the bond markets and I suspect for all types of markets. I think we've gotten some actual data on the inflation print. That's regular data once a month. I think that one we'll be able to pay close attention to.

That's clearly one risk. I think the second, which is related to tariffs, is let's assume that the tariff policy is going to be starting from the US side of things. In President Trump's first term, I think it's fair to say the rest of the world was surprised and unprepared for this type of policy from the US. It was a pretty radical departure from the post-World War II policy from the US, but this time around the rest of the world, they've got their retaliation lists ready to go, and the world is better prepared.

Miscalibration on that front where the US tariffs folks and then we get tariffed back and it leads to a quick decline in US and global growth, I think that's a risk to be aware of as well. The last one I'll say is that there's a lot of weakness in the global growth environment. Europe, Germany is in a recession. China is struggling with growth there as well. This may be more of a risk for the spread markets, but if rates seem like-- and this rise in interest rates does not seem to have bit or really impacted growth to any great extent at this point, but whether or not we're just missing that and there is a bit more of a global growth deterioration combination of the rate hikes, plus the global environment and that all comes together, I think that's probably the third area that I would highlight.

Anu: Yes, absolutely. I think just to summarize the key risks, like inflation tariffs and weakness in global growth, those are all important things to keep an eye on. As I often think when people answer this kind of question, asset management is a very humbling business. Yes.

Ashok: Yes, that's for sure. One day or one week you can feel like you're getting everything right, and then the next day or week, it's 180 degrees spun around.

Anu: Absolutely. Well, Ashok, thank you so much for sharing those thoughts today. I can't let you go without a quick bonus question. I know you just got back from a business trip to Asia, so I'd love for you to tell us about your favorite or most memorable part of your travels to the region recently.

Ashok: You asked a bonus question, but I'll take the liberty of two answers. I will say this. One is it's the Chinese Lunar New Year that's starting in a couple of days over there. We were over there for a lot of the preparation and celebrations for that and just a terrific time. It's so many people starting to travel to see their families and the ceremonies and the festivities about it, in addition to the work meetings and client visits. That was the super fun part of it.

The other thing that I'll say that I just find remarkable about, we were in Singapore, Hong Kong, and Taiwan, and I've been going over there as a regular visitor for years, but every time you go over there, the amount of wealth and prosperity that is lifting a lot of different boats in the region and the change we observe or I observe now is India. We weren't in India, but you can feel the influence of a rising India with more wealth and how that money is moving throughout the region.

You can always look around, I think around the world, and see all the negatives. There are things going out there that, yes, a lot of people are making, there's a lot of wealth being created, but it's also lifting a lot of people out of poverty and raising standards. Anu, just before we came on here, we were talking about even places like Thailand where you're seeing the growth of middle classes in this society, and that's a terrific thing to see in perspective.

Anu: Yes, that's great. Thank you so much for sharing those thoughts and for just sharing your perspectives on the 2025 fixed-income outlook. As we've discussed today, very clear that evolving fiscal policies and the new US administration's approach, whether it's tariffs or immigration, investors have a lot to consider as they navigate these Disruptive Forces, you could say. Ashok, appreciate you joining us today, and we look forward to having you on the show again soon.

Ashok: Thanks, Anu, and congrats on the podcast. I know this has been a terrific thing for all of us at the firm, and I hope all your listeners enjoy it as much as we do.

Anu: Thank you. That's very kind of you. To that point, to our listeners, if you'd like to read more about the fixed income views expressed today, please visit our website nb.com, where you can find the Q1 2025 fixed income outlook, as well as our firm's Solving for 2025 publication. If you've enjoyed what you've heard today on Disruptive Forces, you can subscribe to the show from wherever you listen to your podcasts or, again, you can visit our website, nb.com/disruptiveforces, where you'll find previous episodes as well as more information about our firm and offerings.