We believe that good results in the coming year will depend on how well positioned the portfolios are to take advantage of the lowest rateswhile protecting themselves from possible economic and credit volatility. In our view, the key issue in 2025 will be how investors successfully navigate the greater dispersion across investment sectors. fixed income.
A soft landing favors the profitability of fixed income; but will it last?
Until now, the Fed appears to have achieved a “soft landing”, with a decline in inflation accompanied by a gradual slowdown in growth. However, it is worth remembering that, historically speaking, this is how most crash landings begin. The challenge that fixed income investors will face in 2025 will be whether the current economic slowdown continues smoothly or leads to a more significant downturn. The labor market could represent a key factor. If weakness in job creation persists, the economic outlook could deteriorate further.
We believe that the inflation will continue to decline toward the Fed’s 2% target, and the institution will ultimately lower interest rates to below the neutral rate of 3% by the end of 2025. This forecast is based on our view that the labor market and Consumer demand will continue to weaken.
However, two key factors could prompt the Fed to adjust its approach:
1. A stagnation or rebound of inflation. If inflation picks up – especially in basic services – the Fed may have to stop its cutting cycle and stabilize rates in a range of 3%-4%.
2. A major demand shock. A disruption in demand, especially accompanied by the fragility of the labor market, could lead the Fed to cut rates more forcefully, placing them well below the neutral level, as happens in traditional cycles of rate cuts. guys.
Regardless of how things develop, the Fed’s 2025 roadmap remains flexible, with gradual rate cuts expected to reflect the evolving economic situation.
Opportunities in a rate cut environment
In our base hypothesis, We believe the lower rate cycle should create a favorable environment for high-quality US bonds, particularly mortgage-backed and municipal bonds. These sectors, already starting from attractive yield levels, are well positioned to offer good capital gains as rates fall. We take a slightly more defensive stance on corporate credit, given the current level of risk premiums.
For those seeking higher returns, Shorter-maturity high-yield bonds and bank loans offer interesting opportunitiesdespite more expensive starting points. Considering yields of around 7%, these securities could provide attractive returns if defaults are carefully managed.
In case of a rougher landingfixed income markets could experience greater volatility. Such a scenario should benefit high-quality fixed-income securities with longer maturities, as investors seek safe-haven assets in periods of economic stress.
Globally, as the Fed converges with other central banks that have already begun to ease monetary policy—including the European Central Bank and the Bank of England—asynchronous opportunities could also emerge in credit markets. Europeans and Asians. Diverging economic conditions across regions could present interesting entry points for global investors.
Avoid credit dispersion with active selection
Taking into account the evaluations, It seems to us that the market is not yet fully pricing in the possibility of a significant drop in credit around the world.. Therefore, we believe a cautious approach to credit is warranted.
Likewise, we anticipate that credit dispersion will increase in 2025. While high-quality bonds are likely to perform well, some industries could be expected to experience high default rates, potentially exceeding 10% in some sectors over the next two years, while others could remain closer to 10%. %. This divergence is due to the different situation of the balance sheets in the different sectors; Highly leveraged companies, especially high-performing ones, face greater difficulties. As the potential for economic volatility increases, these weaker companies are more vulnerable to credit deterioration. This disparity creates an environment in which active credit selection—Columbia Threadneedle Investments’ core strength—is essential to avoiding potholes and taking advantage of the most attractive opportunities.
Conclusion: fixed income, positioned to reap good results in 2025
Fixed income investors start 2025 on a solid foundation. With yields at attractive levels and the Fed in a favorable rate-cutting cycle, bonds are well positioned to generate strong returns. More importantly, with the so-called “Fed put” – the belief that the Fed will intervene to support the economy in periods of difficulty – bonds are regaining their fundamental role as portfolio diversifiers. This implicit safeguard should give investors confidence that even if economic conditions deteriorate, fixed income markets will remain well supported.
The fact that it will not take a radical macroeconomic change for fixed income performing well is encouraging. Starting yields are currently above their 20-year average in most sectors. The tailwind from lower rates will further boost total returns.