To address this question, let’s revisit the “holy trinity” of economic drivers: inflation, growth and labor. Inflation has trended down, though there’s still room for improvement. Economic growth continues to deliver positive surprises, but sustainability is a question. The labor market, the key growth driver, remains balanced, but the Fed would likely be happy if we see no further cooling in the jobs market.
Interest rates surged late in the year despite continued normalization, as markets digested the potential impacts of looming tariffs and trade spats. During Donald Trump’s first term, the 2018–2019 inflation pattern suggested that tariffs are less truly inflationary and more a one-off price adjustment. But not all tariffs are likely to roll out on day one, so investors should keep a close eye on inflation expectations.
We still expect the Fed to cut policy rates in 2025, as it’s willing to leave inflation higher to keep the labor market stronger. While the Fed currently has two cuts priced in and the market only one, we still see the balance of risks tilted toward more cuts: we expect “air pockets” of soft data over the next year. As we see it, the inflation outlook would have to worsen significantly and/or inflation expectations would need to become de-anchored to justify fewer than two cuts.
Back to the Future for Bond Investors
For bonds, the storyline is “back to the future.” Real, or inflation-adjusted, yields are elevated with policy rate cuts in store, so there’s still opportunity to tap into attractive yields. Monetary policy is less likely to move in lockstep globally, which we think points to diverse opportunities for active investing.
As the Fed continues to reduce short-term policy rates and fears of fiscal pressures push up longer-term bond yields, the US yield curve has quietly been changing shape. At one time inverted, with short-term rates above long-term rates, the curve has taken on a more normal appearance. This creates opportunities in roll and carry—potential price gains as bonds move closer to maturity and toward the neighborhood of lower-yielding short-term bonds. The potential for more policy easing and a sizable pile of cash still on the sidelines could also support bonds.
Credit—notably high yield—still seems attractive. Spreads are relatively tight, but healthy yields signal more potential ahead (Display). Meanwhile, strong fundamentals and positive technical conditions provide a solid ground, in our view. Beyond high yield, we’re finding opportunities across the globe and sectors as the pace of economic normalization diverges regionally.
