Review of our 2025 surprises

1. Emerging market debt (EMD) and emerging market currency will post double-digit returns. This surprise is well on track to be correct as EMD has outperformed, driven by the continued soft landing in the global economy and further central bank easing around the world. For those invested in unhedged EM local bonds, returns were nearly 20% in USD terms.
2. West Texas Intermediate (WTI) oil trades below $50 a barrel. We give ourselves partial credit. As we predicted, an oversupplied market has indeed put pressure on prices, pushing WTI down by almost 20% year-to-date (YTD) from the $70 range, but it did not breach our official $50 target.
3. High yield (HY) bonds outperform investment grade bonds for the fifth consecutive year. This will likely come down to the wire. Thematically, we were correct that it would be a good year for carry with both asset classes up around 7%–8%, though it remains a close race to see which finishes in first.
4. 10-year government bond yields for Italy-France and Germany-Japan converge to zero. We got a 50/50 result for this one. The spread between 10-year Italy and France compressed from 30 basis points (bps) to slightly inverted, as Italian sovereign debt received ratings upgrades from all three agencies, while France ran into fiscal challenges. Germany versus Japan, on the other hand, was incorrect, as the gap between German and Japanese yields remains around 90 bps wide, although it has narrowed from more than 100 bps wide at the start of the year. Directionally, central bank policy is trending in the way we expected. The European Central Bank cut rates down to 2% and the Bank of Japan (BoJ) is gradually hiking rates. We expect more hikes from the BoJ next year.
5. 10-year U.S. Treasury yield trades in a range of 75 bps or less. We again give ourselves partial credit. While the rationale was correct, we were slightly too ambitious in our forecast. With the Federal Reserve (Fed) on hold for most of 2025, the YTD range for the 10-year has been 84 bps, 9 bps wider than our target. Nonetheless, as the market settled into a higher rate regime, this is still the smallest range since 2021.

Introducing our 2026 surprises

1. The U.S. Treasury yield curve is flat out to the 10-year maturity point at a sub-3% yield. 
   While the yield curve steepened in 2025 – resulting in the 10-year U.S. Treasury yield trading modestly above the fed funds rate and the 2s10s curve sloping upwards by more than 60 bps – the 2-year yield remains inverted to the fed funds rate. For this realistic surprise to materialize, a combination of steps must occur:
   • The Fed cuts rates to a level near neutral (2.5%–3%) as inflation continues to normalize, driven by the impacts of tariffs burning off.
   • After ending quantitative tightening in December, the Fed begins expanding its balance sheet next year by buying U.S. Treasury bills to match the growth in currency in circulation. The acceleration in USD stablecoins will also create an additional buyer of bills.
   • The Treasury Department simultaneously steps up its efforts to lower back-end rates by limiting long-end supply and increasing the share of funding via bills (with knowledge that it has captive buyers among the Fed, money market funds and stablecoins). This would all be motivated by the administration’s goal of improving housing affordability through lower mortgage rates.
2. Gold reaches $5,000 an ounce. 
   It’s the perfect tail risk hedge. Either the significant liquidity already sloshing around in the system is ignited by a combination of monetary, fiscal and regulatory stimulus – fueling a surge in economic growth and inflation – or the whole thing ends horribly with equities bursting globally and gold serving as the flight-to-quality safe haven. We also see several thematic upside price drivers for gold:
   • Gold tends to rally after the Fed starts easing policy; over the past 10 rate cutting cycles, gold has risen over the subsequent six months 80% of the time by an average of 11%.
   • Reserve managers should continue buying to further diversify their portfolios.
   • Wealth management platforms continue to accumulate gold as a diversified store of value.
   • Global concerns over fiscal sustainability and geopolitical risks are accelerating the demand for the yellow metal.
3. The U.S. dollar (DXY) reaches a new cycle high. 
   The fear of a “Sell America” movement in the first half of 2025 never materialized. The U.S. capital markets remain the most liquid in the world with the most depth and breadth of any nation. While we may have reached a near-term peak in terms of foreign investor concentration in unhedged dollar exposure, the momentum toward hedging back to home currencies has waned. It appears that the dollar smirk was a short-lived phenomenon and the smile has re-emerged. More recently, the dollar appears to be strengthening on risk-off, even when led by U.S. AI-themed equities. Going back to 1970, the all-time high for the DXY was above 160 in 1985. The subsequent dollar peak was above 120 in 2001. The local high in this cycle was in September 2022 at 114, about 14% above the current level and where we would benchmark ourselves.
4. Spreads in the U.S. high yield market reach a new record low. 
   According to the Bloomberg U.S. Corporate High Yield index, the all-time low in spreads was 233 bps back in 2007. The local low for this cycle was 253 bps and occurred in November 2024. Looking ahead, the credit markets are moving past the negative headwinds of tariffs and on to the positive tailwinds of the One Big Beautiful Bill Act. Corporate fundamentals are strong, and the technical picture looks positive as well. Maturity walls have been extended well past 2026, and the dominant driver of supply has been refinancing. In addition, a rising share of the capital stack is secured, and defaults remain low. The index continues to skew toward high quality as the emergence of private credit has absorbed the marginal borrowers that typically financed themselves in the public HY market at this point in the cycle.
5. The share of the Emerging Market Sovereign Bond index (EMBIG) with negative spreads to Treasuries triples in size. 
   Currently, less than 2% of the J.P. Morgan EMBIG index trades with a negative spread to Treasuries. There are just a few issuers that have achieved this milestone, including China and the UAE, but there is an additional ~12% of the index that trades with a spread between 0 bps and 50 bps. If even a third of that universe grinds into negative territory against the backdrop of a continued global economic expansion next year, the share of bonds with negative spreads would triple from nearly 2% to 6%. We think the most likely candidates for negative spreads are Middle East issuers. There is a massive local buyer base, strong fundamentals supported by oil revenues and likely a certain element of national pride to have their bonds trade through Treasuries, not unlike what China achieved with its dollar bonds. Furthermore, technicals are strong and investor positioning remains muted. If we are wrong, it’s possible that EM crossover buyers, who represent a large part of the market, will hesitate at the notion of buying EM at yields lower than the U.S.