CPD: The year ahead for fixed income markets

How does the current economic environment  impact fixed income markets and which investment strategies are best positioned to benefit?

The forces shaping fixed-income markets found themselves at a confluence of economic, fiscal, and political factors heading into 2025. Inflation dynamics remained in flux, a new Treasury Department was in place to strategise the balance between fiscal and monetary conditions, and Donald Trump’s incoming second administration continues to introduce important dimensions to policy and growth.

This convergence of factors will play a pivotal role in shaping the trajectory of financial markets and determining whether balance can be restored to fixed income markets in 2025.

As 2025 progresses, the above-mentioned economic, fiscal, and political factors have created a landscape filled with both opportunity and risk for fixed income investors as we are likely entering a new regime characterised by higher volatility in interest rates, inflation and credit spreads.

Inflation is dead…or is it?

For years, the forces of economic optimism have prevailed. Asset prices have tested all-time highs, growth has been robust in both nominal and real terms and the labour market remains healthy despite some normalisation. However, inflation – though tempered – continues to cast a shadow and threatens to destabilise the balance.

The US Federal Reserve (the Fed) aims to balance economic growth and, at the same time, prevent inflationary forces from wreaking havoc in fixed income markets. How the Fed navigates this challenge will hinge on a few key factors:

Timeframe informs perspective

This struggle in financial markets has had no definitive conclusion in recent quarters. Inflation was declared dead in Q3 2024, only for it to reemerge in Q4 2024 as the new year approached. Various measures of annualised inflation over a 3-month period suggest inflation gaining strength, while those measures annualised over a 6-month period suggest a more positive outlook (figure one).

Since the December 2024 FOMC meeting, Jerome Powell and the Fed have signalled unease regarding the recent rise in inflation measures, subtly shifting their focus from labour and growth to containing inflation.

Shifting market forces

Market forces can shift in both cyclical and structural ways. Cyclical shifts can occur rapidly, rendering forecasts outdated, increasing uncertainty and driving price volatility across financial assets. Structural shifts typically take longer to unfold and require time to unveil unexpected impacts.

At the start of 2025, the Fed faced a mix of structural and cyclical forces that challenged forecasting and rendered conventional monetary policy less effective in their quest to dampen inflation. For example, cyclical forces such as normalising supply chains, productivity green shoots and contained commodity prices typically support more stable prices. Conversely, structural forces like deglobalisation, rising geopolitical tensions and higher fiscal deficits are often inflationary. To complicate matters further, President Trump’s administration is introducing additional forces to reckon with. Tariffs, immigration policy and pro-business measures are generally associated with wide-ranging outcomes that will require the Fed to carefully assess which factors to prioritise as forecasts are determined and policy is implemented.

Although inflation has declined materially over the medium term, a shorter-term perspective suggests it is not yet dead. Meanwhile, shifting market forces will likely make forecasting more challenging as inflation volatility increases. As a result, the Fed may need to keep monetary policy tighter than previously expected to maintain order in bond markets. 

The treasury strikes back

Scott Bessent, the newly appointed Treasury Secretary in the Trump administration, succeeded Janet Yellen. Bessent, a legendary macro investor and former Chief Investment Officer of Soros Fund Management, worked alongside investing titans George Soros and Stan Druckenmiller.

Renowned for his expertise in global macroeconomic trends, Bessent’s appointment marks a notable shift at the Treasury Department from Yellen’s background in academia and public policy to Bessent’s deep roots in the private sector and financial markets. Thus far, financial markets have received the Bessent appointment with optimism, given the expectation that his policies will include pro-growth and fiscally pragmatic measures.

While this combination will play an important role during his time at the Treasury, other pieces to the Bessent policy puzzle might prove crucial to bond markets.

Over the last several quarters, in both public interviews and written commentary, Bessent has suggested a meaningful shift in policy is necessary to guide the US economy towards a more sustainable trajectory.

A sustainable economy is one that withstands business cycle volatility, achieves price stability, and fosters robust real wage growth. It is an economy that ensures equitable opportunities across demographics. Most critically, it is an economy where inflation is contained, and the underlying forces are decisively countered. Although Bessent’s goal is to contain inflation, the strategies by which that goal is achieved could diverge significantly and have a material impact on financial markets.

Financial conditions

“Jay Powell has been easing. For whatever reason, he felt compelled to ease financial conditions last fall. After the FOMC meetings in November and December the statements were very anodyne, and he walked out and in the press conference gave very dovish guidance that rate cuts were coming, and you had a massive ease in financial conditions. By doing that, what happened? He pushed up the stock market, which benefits the top 20%, and then we’re back to the bottom 50% who don’t own assets, they have debt, and so rates have had to stay higher for longer.”
– Scott Bessent during an interview with the Manhattan Institute 13 June 2024.

Why is Bessent arguing that financial conditions are too easy and for higher rates as a result? This is seemingly at odds with the general market consensus that monetary policy is restrictive, and that the Fed should reduce its policy rate to prevent deterioration in the labour market and a slowdown in growth.

The answer lies in the notion that the US economy today is less sensitive to Fed policy and the level of front-end interest rates compared to prior cycles. This is because the current cycle has been driven by income and wage growth rather than debt, augmented by healthy balance sheets across US households and corporations.

Notably, US household debt relative to GDP is at the lowest level in 15+ years. US Corporate net interest payments as a share of after-tax income are at the lowest level in 60+ years. As a result, traditional measures that inform the appropriate level of monetary policy, like the Taylor rule (a guideline that adjusts interest rates based on inflation and economic output gaps), might be less useful in the current environment.

The US economy exhibited signs of slowing activity and declining growth expectations in Q3 2023 and Q3 2024. In both periods, market expectations shifted sharply toward a Fed cutting cycle, and Jerome Powell reinforced this shift by signalling easing measures were imminent (figure two).

As a result, interest rates declined, asset prices rose, and financial conditions eased. This created a growth impulse while measures of inflation subsequently rose to levels inconsistent with the Fed’s target. This feedback loop later forced the Fed to adjust its dovish stance as interest rates moved higher. Bessent might look to break this feedback loop by tightening financial conditions with the tools at his disposal.

Approach to debt issuance

“I have been very outspoken, and I noticed with great pleasure in the past 48 hours that Senator Kennedy from Louisiana and Senator Haggerty from Tennessee took Secretary Yellen to task for shortening the US debt maturity, which has also eased financial conditions.”
– Scott Bessent during an interview with the Manhattan Institute June 13, 2024

Bessent’s primary tool as Treasury Secretary is the department’s approach to debt issuance (US Treasuries). He has voiced strong opposition to Janet Yellen’s decision to rely on short-term debt issuance during a non-recessionary period, arguing that it has contributed to easier financial conditions and undermined the sustainability of the US economy.

A plausible outcome is a more balanced approach to debt issuance, with a greater reliance on long-term debt. This shift would tighten financial conditions as asset prices, particularly equities and real estate, are more sensitive to longer-term interest rates.

The likely effects would include reduced demand, slower growth, and lower inflation. If these conditions materialise, Jerome Powell and the Federal Reserve would have justification to reduce interest rates, simultaneously alleviating the US federal interest expense burden.

This outcome would result in the following: long-end interest rates rise, financial conditions tighten, demand slows and inflationary forces are subdued.

Return of the Red Wave

Lower corporate taxes, reduced regulation, and the strategic use of tariffs as a negotiating tool defined the economic playbook during President Trump’s first term as president. Fiscal discipline took a back seat while positive animal spirits swept through corporate America.

Capital expenditures and M&A activity surged, hiring accelerated, consumption increased and growth prospects improved. This combination fuelled a surge in asset prices, propelling them to new highs. This was the central storyline of Trump’s first presidency and the red wave in 2016. Will his second term follow a similar path and reach the same conclusion as the original? The clues may lie in today’s economic starting point and incentive structure for President Trump relative to 2016.

The economic paradox: inflation vs growth

Growth in the US has been above five percent in nominal terms for seven out of eight quarters and above 2.5 percent in real terms for seven out of eight quarters. Asset prices, including US equities and housing prices, are at or near all-time highs, while credit spreads are near 20-year lows. The US economy is doing well and does not need more growth, with some arguing it could even benefit from less growth (figure three).

Donald Trump’s victory in the 2024 elections was largely driven by voters prioritising the economy, particularly inflation, over asset appreciation or economic growth.

While growth figures and a healthy labour market suggest the economy is not struggling, prevailing levels of inflation which are well above those experienced in 2016, likely weighed more heavily on voters’ minds.

The administration’s strategic balancing act

The ideal outcome for the Trump administration would involve a balanced approach, combining growth-oriented measures such as lower taxes and deregulation with policies aimed at tightening financial conditions and containing inflation. Augmenting these balanced measures with wins in hot-button voter issues like immigration and foreign policy could help dampen the lack of excitement associated with a benign environment for asset prices during the first year of the new administration.

At the beginning of 2025, the question was whether the new administration could successfully lower inflation at the expense of growth and make good on a key campaign promise to the middle class and restoring order to the markets. The imposition of tariffs on all imports is likely to derail that goal – the extent of the derailment remains to be seen.

Impact on bond markets

Bond markets are at an inflection point. Conditions have been supportive over the last two years, with solid growth, stable employment and record-high asset prices. The interplay of economic, fiscal and political factors has created a landscape filled with both opportunity and risk for bond investors.

Inflation remains elevated (which tariffs won’t help) and bond market volatility is high. A rise in yields, particularly in longer-term maturities, would tighten financial conditions and temper growth expectations. At the front end of the curve, 2-year interest rates just above the Fed Funds Rate and aligned with the Fed’s reaction function to any deterioration in the labour market or growth.

Fixed income specialists Payden & Rygel believe we are likely entering a new regime characterised by higher volatility in interest rates, inflation and credit spreads. Consequently, the ability for portfolio managers to adapt, without being constrained by a bond benchmark, will become increasingly important this year in the face of greater uncertainty.

In a landscape of shifting economic forces, a flexible and adaptable investment approach – or absolute return strategy – is best positioned to deliver reliable income for investors and avoid capital losses on bonds.

What is an absolute return fund?

Unlike traditional bond funds or passive bond funds, where most of the return is driven by the performance of the benchmark (figure four), returns from absolute return strategies are driven by the investment approach adopted by the manager.

An absolute return investment strategy is not beholden to a benchmark; instead, it’s a strategy generally designed to better navigate the complexities of the evolving fixed income landscape than traditional bond funds or passive bond funds that are constrained to managing a fund to a specific benchmark.

Absolute return strategies are typically managed to beat a cash or equivalent benchmark rather than a bond index, thus removing constraints around duration and sector positioning. The portfolio managers are better able to manage the fund’s risk and return profile by utilising all fixed income sectors.

Consequently, absolute return funds typically have lower duration (i.e. are less sensitive to changes in interest rates), a good thing when the interest rate environment is volatile.  At such times, it can be more challenging for managers of traditional funds to make quick changes to allow for a changing economic environment or market circumstances. Absolute return fixed income managers have greater flexibility and can typically make portfolio changes more nimbly.

Why absolute return in this environment?

Inflation dynamics remain in flux as President Trump’s second administration introduces important dimensions to policy and growth such as tariffs and US-focused policies.

An absolute return approach provides fund managers with greater flexibility to adapt to changing market conditions, focusing on reasonable returns relative to cash while prioritising capital preservation.

Investing in fixed income offers a range of benefits, from providing a steady stream of income to reducing overall portfolio risk. With predictable interest payments and principal repayment, fixed income securities can offer stability and preserve capital in uncertain market conditions, while providing diversification benefits to an investment portfolio. In the current economic landscape, absolute return funds are best positioned to provide a fixed income exposure to meet your client’s needs.

The information included in this article is provided for informational purposes only and is general advice only. It does not take into account an investor’s own objectives. The information contained in this article reflects, as of the date of publication, the current opinion of Payden and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Payden & Rygel, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.

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