It’s been a rocky start to the year for fixed interest, particularly government bonds. 10-year Treasury yields shot up to almost 4.8%, while UK 10-year Gilts hit 4.9%. Although they’ve since settled closer to 4.6%, this kind of fluctuation isn’t what we typically expect from a so-called “boring” asset class. So, what should we expect next?
Look behind the numbers
Yields don’t move randomly – they’re driven by growth and inflation. The rise in Gilt yields grabbed headlines, but that was largely due to the market response to reflationary policies in the US. Since the Federal Reserve (Fed) started cutting rates in September, yields have risen - unusual at the beginning of an easing cycle. This was amplified by Trump’s win, and markets reacting to his pro-growth agenda at a time when the economy was already relatively strong.
Source: Bloomberg and Grizzle as at 6 January 2025
In the US, inflation worries are predominantly about strong underlying demand, but in the UK, it’s a different story. Rising costs, higher minimum wages, employers’ national insurance contributions, soaring energy bills and pricier imports (thanks to a weaker pound) are all feeding into a rising inflation outlook.
Given the Bank of England’s (BOE) mandate is financial and price stability, despite a weak economy, they seem to have limited scope to cut interest rates. However, all Government bonds are ultimately priced off US Treasuries, so what the Fed does with interest rates is as equally important.
Which way will the Fed turn?
With US GDP growth for 2025 forecast to be close to 2%, current unemployment low at 4.1% and core inflation at 3.2%, there’s still some distance from the 2% target. There’s no clear and immediate need for further interest rate cuts.
That said, the Fed does appear to have a bias towards easing, given it believes current policy rates of 4.25 - 4.5% are restrictive compared to their projected neutral rate of close to 3%. However, with productivity growth of 2.5% and population growth of 1%, I’d suggest the Fed’s neutral rate might be more like 3.4 - 3.9%, including some risk premium, suggesting rates might not be as restrictive as they’re claimed.
The rising risk premium is exacerbated by expectations of mounting debt and fiscal deficits. In the US, current debt-to-GDP ratio is close to 100%, alongside a fiscal deficit of 6.4% in 2024. If Trump’s planned extension of the Tax Cuts and Jobs Act plus corporate and income tax reductions goes ahead, these figures could soar closer to 130% and over 9% by 2030, according to the Congressional Budget Office. This is clearly unsustainable and understandably, bond investors are demanding higher yields to compensate for the increased risk.
On a brighter note, Scott Bessent, Trump’s appointed Treasury Secretary, is a successful former hedge fund manager known for his prudence and risk control. This offers some hope that tax cuts could be fully funded. Without this fiscal discipline, it’s likely more conservative factions within the Republican Party would object, potentially blocking bills in Congress – something Trump will want to avoid.
Given the heightened uncertainty of Trump’s policies around tariffs, immigration, deregulation and tax, the Fed is expected to be patient, waiting for clearer political policies as well as developments in economic data. This is likely to lead to short-term volatility in interest rates, as high frequency data swings between disappointing, meeting or exceeding expectations.
In the short term, noise shouldn’t distract investors. We encourage taking a step back to better observe the longer-term underlying trends and opportunities shaping the market.
QT and the income opportunity
Right now, the Fed is trimming its balance sheet by $60bn per month through so-called “quantitative tightening” (QT), split between $25bn from Treasuries and $35bn from Federal agencies and Mortgage Backed Securities (MBS).
This has been reduced from $95bn in June last year but is at odds with the Fed’s recent easing bias, as QT adds upward pressure on yields by increasing bond supply. To counter this, the Fed is expected to scale back on QT over time - something the market isn’t currently paying much attention to but could be an incremental positive.
Fixed interest yields are also looking attractive now, not only offering positive real yields above inflation but also sitting above cash rates, and even on a par with equity earnings yields. Compared to their 20-year median, fixed interest yields (other than high yield) look appealing.
Source: BoA, IBES, LSEG Datastream, MSCI and J.P. Morgan Asset Management as at 16 January 2025
Typically, long-term fixed interest annualised returns tend to align with starting yields. With government bonds and investment grade credit currently offering yields of 4.5 – 5.5%, we see this as attractive entry point for investors within a diversified multi-asset portfolio.
Source: Bloomberg, ICE Indices and J.P. Morgan Asset Management as at 3 January 2025
Bonds have had a challenging few years of late, but with the reset higher in yields, we believe they’re reclaiming their spot as a key player in a multi-asset portfolio. They offer reliable, positive real income and uncorrelated returns to equities should a growth shock arise.
While some volatility is still to be expected, given elevated government debt levels, the worst of bond volatility appears to be behind us - good news for fixed interest investors, because bonds are supposed to be boring!
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.
