Duration risk management is much needed, and we see short duration as a better starting point given the downside risk to the economy in the second half of 2025.
Amid strong demand for income, fixed income assets continue to play a crucial role for investors. The ongoing tariff tensions from the U.S., questions over fiscal sustainability and capital flow impacting the USD could complicate the investment outlook for this asset class and require skilled managers to navigate this environment.
The May 12 tariff truce between the U.S. and China has shown that economic and market realities are still relevant to policymakers on both sides of the Pacific Ocean. However, the effective U.S. tariff rate is still four times higher than when U.S. President Trump moved into the White House. The inflation risk to the U.S. economy and the downside risk to the global economy are still lingering. Stretched between these two risks, the Fed seems content to stay put until there is clear deterioration in hard economic data, especially from the job market. This implies that the bullish steepening of the U.S. Treasury yield, or short-end yield falling faster than the long end, is still the most likely scenario.
However, the U.S. fiscal outlook could impact the long end of the yield curve. The reconciliation bill, in its current form, could add over USD 3trillion to fiscal debts. The U.S. federal government debt-to-GDP ratio could rise from 98% in 2024 to 128% by 2035. Fiscal sustainability could keep the long end of the yield curve volatile and elevated. Hence, duration risk management is much needed, and we see short duration as a better starting point given the downside risk to the economy in the second half of 2025.
While the U.S. economy may experience some slowdown, the outlook for the U.S. corporate credit sector remains stable. Investment-grade corporate debt historically does not see a surge in defaults during economic downturns. For high yield corporate credit, the overall fundamentals of the sector have improved as many low-quality issuers have moved to borrow from the private market. This can help manage the rise in default rates. Nonetheless, company selection is important to extract income while managing credit risks.
We do see room for further USD depreciation. This is partly due to the policy direction from the Trump administration. The current account and fiscal deficits require the USD, which is overvalued in our view, to weaken to restore balance. A rebalancing away from USD assets could also contribute to a weaker USD. This would imply international fixed income, including emerging market bonds, could potentially benefit. Since U.S. tariffs could bring inflation to the U.S., but disinflation elsewhere in the world, developed markets and Asian central banks could cut rates more aggressively than the Fed, presenting additional opportunities to investors.