Fixed income outlook for 2025

As we enter 2025, the surge in bond yields remains a defining feature of global markets. Since mid-September, the 10-year US Treasury yield has risen by 100 basis points-a remarkable move, given that the Federal Reserve (Fed) cut rates by the same magnitude during this period. Historically, this is unusual and highlights the growing influence of fiscal concerns, coinciding with the most common measures of term premia reaching their highest levels in years.

Additionally, lingering doubts about the ability of traditional fixed income to effectively hedge equity risk in portfolios may also be a contributing factor, with stock-bond correlations fluctuating between positive and negative territory depending on whether macroeconomic narrative is more focused on inflation or growth.

Although momentum has been a powerful force in markets in recent years, it is worth remembering that traditional fixed income, more than other asset classes, structurally embeds mean reversion in returns. Higher yields may lead to drawdowns in the short term, but they also improve forward-looking return expectations.

A 'bear steepening' trend-that is, long-term yields rising more than short-term yields-and a higher term premium raise the expected excess returns compared to holding cash. In addition, real yields above 2%-as seen in both Australian and US 10-year government bonds-effectively ensure positive real returns on inflation-linked bonds and imply a high likelihood of nominal bonds beating inflation over the typical strategic asset allocation horizon.

Further to this, investors and allocators are well placed to hit their return hurdles-whether nominal or 'CPI plus'-with a higher allocation to traditional defensive assets like government and investment grade corporate bonds.

The evolving macro narrative and the case for duration now

One of the challenges for fixed income investors in 2025 will be separating signal from the noise of constantly shifting market narratives. Amid fears about deficits, increased issuance, bond vigilantes, and all the unknowns surrounding the new US administration, it is easy to get overwhelmed. However, understanding two key concepts, neutral rates and term premia, provides clarity on the forces driving bond yields higher.

Neutral rates

Neutral rates-though theoretical and unobservable-underpin central bank monetary policy. For central banks with dual mandates like the Fed and RBA, they represent the interest rate at which an economy achieves full employment and inflation aligns with targets. Between the GFC and the pandemic, neutral real rates in the US and Australia were considered negative, necessitating nominal policy rates below inflation targets.