Fixed income: Embracing the new, old normal

The Federal Reserve kicked off this easing cycle with a jumbo 50 basis point (bp) rate cut and appears committed to continue lowering interest rates at a reduced quarter percent pace to return to neutral. At time of writing, the committee has already delivered 75bps worth of cuts, lowering policy rates from 5.25%-5.50% to 4.50%-4.75%; however, a data-dependent Fed suggests the outlook for further easing remains uncertain. What does appear certain is the committee’s desire to lower rates by enough to ease restriction on the economy, but not by too much to encourage inflation. This goal is, of course, very difficult to achieve, but slowing, yet stable growth and easing price pressures provide runway for continued cuts through 2025.

But how low does the Fed go? In an environment of heightened uncertainty, forecasting Fed action this cycle has been difficult to say the least. The most hawkish Fed governor expects just two more 25bps rate cuts might be sufficient, while the most dovish members expect to cut rates by a further 175bps by the end of 2025.

Markets expect a more hawkish outlook with roughly 75bps of additional cuts through next year before pausing (Exhibit 1). While the Fed would like to reduce rates to roughly 3.00%, a fully controlled Republican government and the potential for tariffs next year and fiscal thrust in 2026, could lead to a premature end to the cycle.

While investors are likely to be myopically focused on the pace and magnitude of rate cuts next year, investors should take a step back and recognize that the Fed is still in cutting mode in 2025, with the bar to pause cuts or to raise rates set extremely high. However, if the Fed felt that the incoming administration would push through policies that lead to higher federal deficits and supply-side constraints that could boost inflation, they might consider a pause in their easing plans. That said, getting rates to neutral appears to be top priority, suggesting it’s unlikely policy rates fall below 3% outside of recession. Importantly, rates have returned to the pre- Global Financial Crisis “normal” of positive real rates. Given this, reinvestment risk in short-term bonds is high and investors will need to consider other areas of fixed income to achieve their income and return goals.

Fed rate cuts tend to lead to higher rate volatility as evidenced in previous rate-cutting cycles. Moreover, we see the long end of the curve being influenced by next year’s fiscal policy discussions, as well as potential inflationary impacts. With that said, yields have recently backed up and we believe long-term interest rates as measured by the nominal U.S. 10-year Treasury yield should be biased modestly lower from current levels (albeit with intra-year volatility). We see the 10-year yield stabilizing between 3.75%-4.25% in a soft landing scenario, which remains our base case, and below 3.5% in a hard landing scenario.

All things considered, the 2025 fixed income playbook is:

• Extend duration out of cash: After falling to 3.6% in 3Q24, long-term interest rates are comfortably above 4% again, giving investors another bite at the “duration” apple. Even if long-term rates are pressured slightly higher by rising debt levels, there is enough income to offset bond price losses. As the yield curve shape continues to normalize toward its steeper slope, reinvestment risk is real on ultra short-duration bonds.
• Embrace credit for the yield, not the spread: We like high-quality duration in securitized markets like agency MBS and asset-backed securities. We also favor the full spectrum of corporate credit (IG, high yield, bank loans and convertible bonds). These sectors would benefit in a soft landing scenario and continue to provide attractive yields even though spreads remain tight.
• Search for value: Municipals are trading close to their cheapest levels this year and long duration municipal bonds offer meaningful tax-equivalent yield pickup relative to Treasuries.

Overall, the current backdrop suggests the new normal interest rate environment looks a lot like the “old” normal before 2008: attractive yields, tight spreads, positively sloped yield curves and higher income. To that end, an active approach to bond investing will be key to finding attractive relative value opportunities while balancing risks with higher rates.

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