Throughout 2024, the path to economic normalization continued. Federal Reserve (Fed) policymakers made substantial progress bringing inflation closer to target and labor markets moved better into balance – all without triggering a recession. This allowed the Fed to kick off its easing cycle after the second longest pause (i.e., the time between the final rate hike and the first rate cut) on record. While rate cuts have traditionally been supportive for the bond market, this cycle continues to beat to its own drum. In a departure from the historical pattern typically seen after Fed rate cuts, Treasury yields have marched significantly higher since the Fed’s initial rate cut. As we step into 2025, the outlook for fixed income remains favorable (particularly for short to intermediate bonds) but there are plenty of risks on the horizon that could knock the bond market off course.
Shallower easing cycle
The Fed’s 100 basis points (bps) of ‘insurance’ cuts in 2024 have prolonged the economic expansion, which has been ongoing for 19 consecutive quarters. While downside risks to the job market were mounting last summer, the Fed’s jumbo-sized 50 bps rate cut last September—followed by two additional 25 bps rate cuts in November and December – helped the economy dodge a downturn. This, combined with the burst in optimism following the presidential election outcome has bolstered the case for a soft landing. As a result, the US economy is entering 2025 with considerable momentum.
The better than expected economic backdrop has altered the outlook for the Fed’s expected rate path. Policymakers can afford to be patient with future rate cuts as there is no longer a pressing need to stimulate growth now that the downside risks to the economy have dissipated.
This has implications for the bond market. With the market now discounting that the Fed’s terminal rate plateaus at a higher level than Fed officials’ current 3.0% estimate, it means we are unlikely to see a meaningful decline in bond yields from current levels. But with a soft landing coming into focus in 2025 and significant policy uncertainty on the horizon, yields are likely to remain range-bound for much of the year. However, gentle upward pressure on longer maturities is likely as yields factor in a modest risk premium to reflect the growing list of uncertainties on the horizon.
Risks are tilted modestly to the upside
Shorter-maturity yields are often considered a proxy for the near-term rate outlook. With the fed funds rate likely to settle in the vicinity of 4.0% next year, a 2-year Treasury yield of ~4.3% seems attractively priced based on current Fed rate cut expectations.
However, longer-maturity bonds could see a gentle upward shift. Why? That’s because longer-term bond yields are primarily driven by expectations for growth and inflation, and to a lesser extent, should incorporate some additional compensation to reflect the deteriorating fiscal outlook. With the economy still growing at an above trend rate, the disinflationary trend stalling, and the nation’s debt and deficits at unsustainably high levels (and still rising), we are growing more cautious on longer maturities. That is why we have raised our 10-year Treasury yield target to 4.50% for 2025. However, we are more inclined to play the ranges this year, adding duration when yields overshoot and cutting duration as yields move back toward 4.0%. Absent another growth scare (not our base case), we see limited room for a meaningful decline in Treasury yields from current levels. Given the uncertainties that lie ahead, here are three factors that could put modest upward pressure on bond yields in 2025:
- Inflation plateaus at a higher level.
- Deteriorating debt dynamics.
- Fed's neutral rate shifts higher.
Bottom line
While we do not anticipate a meaningful decline in bond yields in the year ahead, the outlook for bonds in 2025 remains favorable. With yields remaining historically elevated (at least relative to the last 15 years), investors still have an opportunity to capture reasonable income from the fixed income side of their portfolios. Although with plenty of potential risks on the horizon, investors need to remain vigilant. We remain cautious on taking on too much duration risk (a measure of interest rate exposure) in the current environment and believe the risk/reward is more attractive for short to intermediate maturities, particularly in light of our view that the Fed’s easing cycle should continue in 2025. We also favor high-quality corporate and municipals bonds – which can benefit from solid fundamentals and yields that remain at historically attractive levels.
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