Unconstrained fixed income views: February 2025
Things remain the same, but everything is changing…
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We have left our probabilities unchanged since last month, with a soft-landing scenario remaining our baseline view and a no-landing scenario—by which we mean we expect no further cuts from the US Federal Reserve (Fed) this cycle—a significant tail risk. But there have been plenty of developments to consider as we assess how our scenarios might play out.
Source: Schroders Global Unconstrained Fixed Income team, February 2025. For illustrative purposes only. "Soft landing" refers to a scenario where economic growth slows and inflation pressures ease; “hard landing” refers to a sharp fall in economic activity and additional rate cuts are deemed necessary; “no landing” refers to a scenario in which inflation remains sticky and interest rates may be required to be kept higher for longer.
A hawkish warning from US payrolls and CPI…
On the one hand, we have seen another strong US labour market report, as well as persistently low initial jobless claims, suggesting that the labour market in the US has stopped loosening and could, in fact, be retightening. Certainly, the figures are stronger than the Fed’s expectations, considering that the current unemployment rate of 4% is well below their forecast for the end of 2025 (4.3%). On the other hand, January saw a strong inflation number well above levels consistent with the Fed’s target. So, on both sides of the Fed’s mandate, February has seen hawkish surprises.
Shouldn’t the no-landing risks be rising, then?
We don’t think so. In isolation, of course, both the above developments make it likelier that the Fed is either unable or unwilling to cut interest rates again. But they’re not in isolation, and there are several other important factors we believe need mentioning – primarily energy, trade and consumption.
Firstly, while we undoubtedly were surprised by the strength of January inflation, there were several idiosyncratic drivers, such as notably strong vehicle insurance costs, which could see some reversal next month. Other technical factors, such as residual seasonality, also likely contributed in the outsized strength of the inflation. Leading indicators for inflation still look benign—such as the small business NFIB prices survey. Most importantly, oil prices have fallen significantly since our last update.
We believe energy prices are a crucial component of the inflation process, and this decline is a welcome signal for future inflationary pressures. Indeed, at any level below US$75 for WTI, oil prices will provide a disinflationary pressure to headline inflation for the rest of the first half of 2025. The further prices fall below this threshold, the greater the disinflationary impulse.
Secondly, we have witnessed the early stages of President Trump’s plans to alter the global trade framework. The ultimate outcome of this process is uncertain, and we have already seen that he will take a transactional stance in his dealings, which means that some countries might be able to mitigate or remove the imposition of US tariffs with the right concessions. Nonetheless, we believe that the start of the disruption to global trade so early in his presidency will be seen by the market as a mildly negative factor for future growth, even if current growth indicators remain strong. Meanwhile, efforts to cut government spending and improve efficiency (e.g. the efforts being led by the administration’s ‘DOGE’ initiative) provide modest negative impacts for both demand and employment in upcoming months.
Finally, the strength of consumption in the fourth quarter was a factor in our previous increases of the no-landing scenario. But we see evidence that some of this strength was due to consumers front-loading of purchases in anticipation of potential tariffs (and higher prices), similar to their behaviour at the end of 2017. If this is the case, we expect to see payback in Q1 2025 consumption data. To be clear, we maintain the view that consumption will be positive. But having been “too hot” in Q4 2024, we think this moderation will move us back towards “just right” in Q1.
What does this mean for bonds?
Although our probabilities have remained unchanged over the month, bond markets have shown signs of pricing in a higher probability of a no-landing outcome, for instance in option-pricing models. We believe they now reflect a more realistic probability of the Fed not cutting rates again this year, which reduces the scope for a hawkish repricing from here. In other words, as the market revises its view towards “no 2025 cuts”, it is less likely to be caught off guard by further data indicating a stronger economy and / or higher inflation.
Furthermore, the past month has seen moves to ease regulation and support demand for US Treasury bonds, resulting in a rapid outperformance of cash bonds versus swaps. Given heavy consensus positioning the other way, this improved performance of cash bonds versus swaps is likely to continue, providing another supportive technical dynamic for the cash bond market.
We remain tactically constructive on US 10-year bonds given current valuations, stretched negative sentiment and supportive technical factors aligned with our soft-landing baseline. However, our targets in this regard are modest, unless (or until) we see clearer signs of an increased probability of a hard landing, which currently remains a small tail risk.
We have turned neutral on duration in Europe and the UK. In Europe, while the economy remains stagnant, we have noted a pause in downside momentum and a reduction in severe recession risks.
Market pricing for the European Central Bank (ECB) has shifted in a more dovish direction over the past month, which we believe is justified but now offers less attractive risk-reward asymmetry. We will be closely following both the German election and the impact of increased defence spending on fiscal policy, viewing both as supportive of a continued steepening of European curves.
In the UK we have seen a significant rally over the last month, as some of the ‘fiscal risk premium’ that built up in early January has unwound. However, similar to the Eurozone, we consider market pricing for the Bank of England (BoE) as fair but lacking in attractiveness.
Where are the opportunities?
Our preference for agency mortgage-backed securities (MBS) over US investment grade credit has worked well over the past month. Since valuations remain attractive and interest rate volatility has decreased, agency MBS remains our highest conviction overweight in asset allocation.
Similarly, our preference for short-dated European investment grade credit has worked out well, with this area outperforming the US over the past month, and we still see opportunities here. We continue to be wary of high-yield credit globally, however, due to stretched valuations.
Covered bonds have been a high conviction position for us, but we have slightly tempered our enthusiasm as their attractiveness has diminished. We hold a very favourable view on French covered bonds, but we see fewer opportunities elsewhere at current valuation levels. Instead, we now see increasing potential in areas such as quasi-sovereign and supranational issuers.
As noted above, in macro trades we remain tactically constructive on US duration. But given heavy consensus in favour of curve steepening, and some technical factors moving against this, we have downgraded our view on steepeners to a more neutral stance. This is an area we will likely revisit in coming months, but for now we remain in a ‘wait-and-see’ mode.
We believe breakeven inflation has become expensive, with the best way of expressing this view being through Eurozone breakeven steepeners (that is, expecting Eurozone breakeven inflation rates to fall more at shorter maturities than at longer), which currently offer an attractive risk-reward profile.
Lastly, we retain a moderately positive view on the US dollar.
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