Unconstrained fixed income views: May 2025
Recession risks have fallen and some parts of the bond market have already moved swiftly to price that in.
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Market recession fears have quickly abated courtesy of President Trump dialling back his aggressive stance on trade – most notably a 90 day pause on reciprocal tariffs and a reduction on escalatory tariffs against China. Adding to this - so far at least - economic data is holding up relatively well, with the US economy looking to have escaped the worst-case scenario.
What does this mean for our scenario probabilities?
An improved growth outlook saw us downgrade the probability of a ‘hard landing’ to 15% (from 35% last month). Our base case for some time has been one of a ‘soft landing’, and we raise the probability to 65% (previously 55%) to reflect our increased conviction in this view. However, we remain acutely aware of the inflationary consequences of tariffs and what it means for US Federal Reserve (Fed) policy, and this motivated an increase to our ‘no landing’ probability to 20% (from 10%).
For illustrative purposes only. "Soft landing" refers to a scenario where economic growth slows and inflation pressures ease, allowing modest further rate cuts; “hard landing” refers to a sharp fall in economic activity and deeper 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.
The US economy looks resilient… so far
We recognise it may be too early for the tariff-induced uncertainty to have hit the real economy, but the impact so far appears to be less damaging than initially feared. Nevertheless, we still expect the US economy to slow in the coming months as the uncertainty created by Trump’s fluid trade agenda translates into a difficult business environment.
On inflation, while the latest US inflation release for April point to only a minor impact from tariffs coming through so far, businesses are already warning of higher prices and we expect this to begin to show up in official data through the summer. All this puts the US Federal Reserve (Fed) very much in a wait-and-see mode.
Elsewhere in the world…
In mainland Europe, positive fiscal stimulus out of Germany, combined with easier financial conditions are helping to support a positive medium-term trajectory for growth. Early signs of Chinese credit stimulus also support this view.
In the UK, the most recent Bank of England (BoE) meeting was a timely reminder to the market not to get ahead of itself in terms of pricing too many interest rate cuts. With a number of near-term inflation risks circulating, such as an increase in payroll taxes and the minimum wage increase which took effect in April, the BoE reiterated its “gradual” mantra with respect to monetary policy.
Where does that leave us on government bonds?
At current levels, valuations in the US do not look that attractive and warrant a neutral score. Although should economic data weaken more materially from here, we think there is scope for US yields to move lower (yields move inversely to price).
From a cross-market perspective, we favour short positions in Germany. This is premised on the fact that European Central Bank (ECB) has eased monetary policy quite a bit already, combined with our relatively upbeat growth outlook.
Our key asset allocation views
We have downgraded our scores across corporate credit given the sharp rebound in this asset class and therefore less attractive valuations. We retain a preference for the front end of curves (i.e. shorter maturity 1 to 5 year bonds) in both US and euro investment grade (IG), where we see more value compared to longer maturity bonds. Agency mortgage-backed securities remain a favoured long.
We believe sovereign, supranational & agencies (SSAs), particularly EU bonds, offer good value on a relative basis as they have lagged the positive performance seen in other sectors of the European bond market. Similarly, within eurozone government bond markets, we prefer semi-core (such as France) versus peripheral markets due to relative valuations.
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