Fixed Income Briefing January 2025

• The Federal Reserve, as expected, kept rates on hold at their January meeting. The monetary policy statement is now characterising labour market conditions as ‘remaining solid’ (previously ‘generally eased’) and inflation as ‘remaining somewhat elevated’ (previously ‘has made progress toward the Committee's 2% objective’). Powell also clarified that the Fed does not require inflation to reach its 2% annual target before considering interest rate cuts. Nevertheless, expectations are that the Fed will maintain a pause in rate hikes until greater clarity emerges regarding both Trump administration policies and inflationary trends stemming from these policies and a resilient labour market. Traders will now be looking at December's PCE data due on Friday for further indications of the trend being in line with policy projections or not. Since President Trump’s re-election in November and his inauguration earlier this month, investors have been anticipating increased volatility and appear to be defensive in their portfolios due to uncertainties around the Trump administration's policies, particularly in relation to tariffs, and their possible impact on yields and the USD. In addition, investors are leery of the rising US debt and proposed changes in US tax policies that may exacerbate debt levels.
• The dollar index was volatile in January due to uncertainty around Trump’s tariff, but was very badly hit by the drop in tech stocks, particularly in Nvidia shares, on 27th January. However, there has been some recovery since and the index is -0.50% MTD. The dollar had been rallying on expectations that President Donald Trump will increase tariffs on the US’ main trading partners, thereby pushing inflation upwards and limiting the Federal Reserve’s ability to cut interest rates. The US labour market continues to show strength with the December nonfarm payrolls at 256,000, up from 227,000 in November. Inflation was down in December, with headline CPI rising 2.9% in December compared with the same month last year, up from November’s 2.7% rate. On a monthly basis, the CPI rose 0.4% in December compared with 0.3% in November. Core CPI, which excludes volatile food and energy prices, rose 2.6% on an annual basis and 0.2% on a monthly basis, compared with 0.3% in November.
• On the growth front the US continues to show strength but with growth moderating. The Flash Composite PMI in January came in at 52.4, down from December’s 55.4 and a 9 month low. The Flash Services PMI was also down, coming in at 52.8 from December’s 56.8 and also a 9-month low. The Flash Manufacturing PMI came in at a 7-month high at 50.1, up from December’s 49.4. 
• However, consumers are feeling less confident. The Conference Board's consumer confidence index declined by 5.4 points in January to 104.1. December's reading was revised up by 4.8 points to 109.5 but was still down 3.3 points from the previous month. The Present Situation Index—based on consumers’ assessment of current business and labor market conditions—fell sharply in January, dropping 9.7 points to 134.3. The Expectations Index—based on consumers’ short-term outlook for income, business, and labor market conditions—fell 2.6 points to 83.9, but remained above the threshold of 80 that usually signals a recession ahead. The University of Michigan consumer sentiment survey US consumer sentiment in January fell to a three-month low of 71.1 from 74 in December, largely due to growing concerns about unemployment and the potential inflationary effects of upcoming tariffs. Long-term inflation expectations rose to 3.2% from 3% in December, while short-term expectations increased to 3.3%, the highest level since May.
• Treasury yields were also volatile in January. There are concerns that any further rise in bond yields, due to reaction to tariff announcements, stronger growth or other macroeconomic uncertainties, may derail the Fed cutting this year. The yields on 10-year Treasuries are over 100 bps higher than their September lows despite the Fed lowering its target policy rate last year. According to the CME FedWatch Tool, there is only an 18% chance of a 25-basis-point cut at the March meeting.

Yield swings

US Treasury yields have steepened this month so far as investors anticipate the potential impacts of new Trump administration policies. Tariffs and tighter immigration rules could exacerbate price pressures. However, looser regulations and a more protectionist policy agenda could also encourage higher growth. Both would increase the risk of reflation and make it more difficult for the Fed to cut rates.

Source: FactSet

Source: FactSet 5:00 PM EST 29 January 2025

Global Economic and Market Review

US yields had largely been rising since Trump’s election in November as concerns around his tariff policies and the inflationary impact these would bring, along with rising debt levels in many countries thanks to rising interest rates. In the UK, the situation for bond markets has been particularly volatile with yields spiking earlier in the month before recovering some ground in the latter part of the month and the pound dropping, with some suggesting that the UK might be in a “debt death spiral” given the ever increasing costs of servicing debt, inadequate tax revenues, and rising social costs. As noted by JPMorgan Private Bank, the US yield on longer-dated government bonds compared to interest rate swaps (which don’t face the same supply and demand dynamics) has remained stable since the middle of last year. This contrasts with the rising discount assigned to long-dated sovereign debt in the UK, where investors have expressed more concern over the country’s ability to service its debt. Inflation is still not in line with the BoE’s target rate of 2% but is slowing. The headline rate rose by 2.5% in the 12 months to December 2024, only slightly below November’s 2.6%. Core inflation, which strips out volatile food, energy, and alcohol inputs, also rose by less than expected. The measure rose 3.2% on the year, below forecasts, and down from 3.5% in November. This did provide some relief to the Treasury and may have given some room for the Bank of England to cut rates at its first meeting of the year on 6 February. However, according to the BoE, headline inflation is expected to increase to around 2.75% by the second half of 2025 as weakness in energy prices falls out of the annual comparison, which will likely reveal the continuing persistence of domestic inflationary pressures. One of the chief concerns for markets is that the growth picture for the UK is not promising. The S&P Global Composite PMI, although rising from 50.4 in December to a three-month high of 50.9 in January, has, according to S&P, now been at such a low level as to signal zero GDP growth for three successive months. The survey suggested that a loss of confidence was driven partly by the payroll tax increase on businesses announced in the 30 October budget. Firms’ expectations for activity in the year ahead were the most pessimistic since late 2022. The Flash Services PMI also dropped to 50.0, down from October’s 52.0 and also a 13-month low. The Flash Manufacturing PMI continued to fall and reached a 9-month low, hitting 48.6 and down from October’s 49.9. In addition, consumer confidence is down with the GfK Consumer Confidence Index for January falling by five points to -22 in January. Consumer expectations for the economy over the next 12 months fell by eight points to minus 34, the worst in almost two years.

The likelihood of a cut on 6 February is around 92%, according to interest-rate swaps data and there is a 49.8% chance of a cut in August. BoE policymakers are likely to be concerned that labour market data continues to show inflationary pressures despite a weakening job market. According to the Office for National Statistics, pay excluding bonuses rose 5.6% in the three months through November from a year earlier, up from 5.2% the previous month. It was strongest in six months and slightly above the 5.5% expected by economists. Private-sector pay growth also accelerated, rising to 6% from 5.5% in the three months through September. However, employment is falling, with unemployment edging up to 4.4% in the three months through November, from 4.3% in the three months through October. The number of employees on payroll also hit the lowest level in over a year after falling by 47,000 in December. This was the largest drop since the end of 2020. February's MPC meeting will be accompanied by the publication of a new Monetary Policy Report. This could well contain further information about what the Bank of England expects to happen this year.

In the eurozone, markets are fully expecting a further 25 bps cut at today’s meeting. Eurozone inflation rose 2.4% from a year ago in December, up from 2.2% in November. Core inflation, excluding volatile items such as food, energy, alcohol, and tobacco, stood at 2.7%. Services inflation came in at 4.0%. On the growth front, the eurozone Flash Composite PMI exceeded expectations with the HCOB Flash Composite PMI rising to 50.2, surpassing the expected 49.7, and up from December’s 49.6. However, the manufacturing sector remained in contraction for the 31st consecutive month coming in at 46.1. This was still better than December’s 45.1 and an 8-month high. The service sector came in at 51.4, down from December’s 51.6. Markets remain worried by the possible trade tariffs from the Trump administration.

German 10-year yields rose in January. The German 10-year yield was +120.30 bps as of 29 January at 2.578%, while the UK 10-year yield was +1.50 bps as of 29 January at 4.624%. The spread between US 10-year Treasuries and German Bunds expanded to 195.4 bps over the month. The gap between Italy and Germany's 10-year yields, a gauge of investor sentiment towards the eurozone's more indebted countries, is, according to Worldgovernmentbond.com, now at 108.8 basis points.

Global bond markets are likely to continue to remain volatile in Q1 as more of President Trump’s policy measures are announced. The Fed is unlikely to cut rates during its March meeting as during his press conference, Fed Chairman Jerome Powell stated that it is premature to assess the effects of the President's policies and affirmed that the central bank's 2% inflation target remains unchanged.

The slowdown in Europe along with growing concerns around the UK’s future growth trajectory and debt levels, are likely to contribute to currency depreciation in the euro area, while the Pound Sterling may also come under pressure on growth fears. Although a ceasefire has been brokered between Israel and Hezbollah in Lebanon and Gaza, the risks of widening tensions in the Middle East have not fully dissipated, particularly as President Trump has suggested a more aggressive stance towards Iran. Although Trump has announced he would impose more sanctions on Russia if it refused to end its ‘ridiculous war’ in Ukraine, there are still no obvious signs of movement. And of course, there are still signs of growing trade fragmentation due to the threat of rising tariffs between the US, Europe and China, which will continue to affect yields and, in turn, the US dollar. In addition, China still appears to be suffering weak domestic demand despite stimulus packages announced last year as the official PMI for January came in at 49.1, below an estimated reading of 50.1. In addition, China’s industrial profits in 2024 fell 3.3% from the previous year, extending declines to a third consecutive year.

Given the expected high level of volatility that will likely play out in bond markets over the next few months, investors may wish to consider adding in some inflation protection into their portfolios along with yield-spread targeting. As the US economy remains relatively strong with the labour market also remaining robust, there is little urgency for the Fed to ease policy. There is a risk that inflation, while slowing, could reaccelerate due to broad tariffs that could be slapped on a slew of imported products. There is also the impact of deportations in the US which began this past week, that could cause a spike in wage pressures. Although the ECB is likely to continue to cut rates in an attempt to boost growth, with 100 bps of cuts expected this year with the majority occurring in the first half of the year, this will be dependent on the below-trend growth and inflation risks remaining under control. 

Key risks

• Inflation risks re-emerge, weighing on asset prices. Inflation appears to be on the up once again with wage increases still above the central banks target. There are also risks that headline inflation may rise due to some commodity prices rising if the tariffs threatened by Donald Trump do indeed come into being. High energy prices and competitive pressures from China and the US are already challenging European industry. As noted by Lazard Research, the EU faces tough choices: conciliating the US with LNG purchases and defense spending may not prevent tariffs, and increasing tariffs against China may not gain support from EU member states like Germany.
• Policymakers over or undershoot. Central banks are being very cautious about getting the balance right between supporting their economies while bracing themselves for further inflationary pressures. The Fed has no need at this stage to cut rates further despite a strong labour market as the “quits rate", a proxy for labour force confidence, is at a five-year low. The dollar is likely to be supported by higher yields on rising inflation expectations (should tariffs come into being as suggested). This means that we will see the monetary policy divergence between Europe and the US continue to grow. The UK will likely continue to try to balance weak economic growth and sticky inflation, but may be upset by bond markets fears around fiscal policy.
• Geopolitical tensions and events. The war in Ukraine is still a risk for European economies, although there are growing expectations that the war will be ended due to increasing pressure from the US. There are still ongoing tensions in the South China Seas between China and the Philippines. The new Trump administration has already upset its NATO allies by demanding they pay more of their budgets into defence as well as purchase more energy from the US. 

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