Moderating inflation and near-trend economic growth will allow most major central banks to bring policy rates toward neutral in 2025. Market expectations have fluctuated throughout the year and are now more aligned with central banks. Consequently, we expect the upside for sovereign bond performance is likely limited.<\/p>\n
The US Federal Reserve initiated its easing cycle with a 50-basis point (bp) cut in September, responding to a labor market slowdown and reduced inflationary pressures. Similarly, the European Central Bank (ECB) and Bank of England (BOE) have cut rates, driven by weak domestic growth and decelerating, yet still elevated, inflation. Japan is an exception, facing continued inflationary pressure exacerbated by a weak currency and slow economic growth. The Bank of Japan (BOJ) has signaled its commitment to gradually increasing policy rates.<\/p>\n
Moderating inflation in 2025, even if it remains above target rates, gives central banks the leeway to cut policy rates, increasing the likelihood of a soft landing. While central banks are not fully transparent about their policy plans, their estimates of the neutral rate, or R*, provide insight on their intentions. Indeed, the Fed\u2019s median Federal Open Market Committee (FOMC) members\u2019 long-run policy rate expectation is 2.9%, equivalent to their current R* estimate. The Fed anticipates a gradual approach to reach R*, aiming for 2026, based on their latest released estimates. The ECB and BOE have less distance to ease to reach neutral, while the BOJ needs to move in the opposite direction. Still, markets are pricing in easing of roughly 85 bps in the United States and the United Kingdom and 148 bps in the euro area.<\/p>\n
Market expectations have converged toward those of central banks over the last year and now look reasonable based on current growth and inflation conditions. We reckon expectations will remain volatile as policy uncertainty stemming from the US presidential election results have broadened the range of potential economic outcomes.<\/p>\n
TJ Scavone, Senior Investment Director, Capital Markets Research<\/em><\/p>\n In 2025, bonds will likely outperform cash, driven by supportive economic conditions and attractive valuations. However, the outcome of the US presidential election could counter these tailwinds if Trump fully implements his policy proposals. Consequently, we maintain a neutral stance on high-quality bonds and duration exposure.<\/span><\/p>\n Cyclical conditions support high-quality bonds. Inflation has declined and the imbalances in the labor market have closed, while we expect economic growth to remain close to trend across developed markets. This scenario increases the likelihood of continued disinflation. As a result, we anticipate lower policy rates next year as central banks focus more on labor market weaknesses than inflation. As this happens, cash yields will likely fall below bond yields, making cash less attractive. High-quality bonds typically deliver higher returns, both in absolute terms and relative to cash, when inflation and growth slow, central banks ease monetary policy, or the yield curve slopes upward. Most of these conditions are moving into place heading into next year.<\/p>\n However, the US presidential election outcome could somewhat offset these factors. Trump\u2019s proposed policies on taxes, tariffs, and immigration likely pose an upside risk to bond yields if fully implemented, all else being equal. This concern contributed to ten-year US Treasury yields rising roughly 40 bps in recent months. As a result, some of this risk is now reflected in the price and yields are beginning to look somewhat elevated compared to economic fundamentals. US ten-year Treasury securities currently yield 4.2%, which is above our estimated fair value yield of 4.1%. Furthermore, while these policies could temporarily inflate consumer prices, their impact on growth is more uncertain and could detract from GDP growth next year.<\/span><\/p>\n Given this uncertainty, we recommend a neutral allocation to high-quality bonds. While we do not see enough evidence to support a tactical overweight at this time, we advise against reducing exposure in favor of shorter-duration assets or cash, given cyclical tailwinds and attractive valuations.<\/p>\n TJ Scavone, Senior Investment Director, Capital Markets Research<\/em><\/p>\n Inflation-linked bonds (linkers) are set to generate solid returns in 2025 due to higher real yields and favorable global economic conditions. While we expect disinflation to continue, we also anticipate breakeven inflation rates will remain rangebound.<\/span> 1<\/a><\/sup> Therefore, we believe linker and nominal bond returns will be similar next year.<\/p>\n The real yield on the Bloomberg World Government Inflation-Linked Bond Index reached 1.5% as of November 30, which is back within its pre-Global Financial Crisis (GFC) range. With real yields well above zero, linkers once again provide a positive real return and serve as a viable inflation hedge. In fact, linkers are among the few major asset classes we expect to deliver positive real returns in another inflation shock, according to our scenario-based return projections.<\/p>\n In 2025, linkers should benefit from similar cyclical tailwinds as nominals. However, linkers tend to outperform nominals when inflation expectations rise. The next year looks mixed in this regard. Inflation has fallen substantially from its post-pandemic peak, and we expect it to continue moving toward central banks\u2019 targets. This will likely cap market-based inflation expectations. Currently, ten-year breakeven inflation rates in the United States are 2.3%, which is firmly within their post-pandemic range. On the flipside, we see limited room for breakeven inflation rates to fall below their post-pandemic lows absent a recession. As such, we expect breakeven inflation rates to remain rangebound in 2025.<\/p>\n![\"\"](\"https:\/\/publishedresearch.cambridgeassociates.com\/wp-content\/uploads\/2024\/12\/2024-12-Outlook-Central-Banks-Celia.png\")
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\nBonds Should Outperform Cash in 2025<\/h2>\n
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\nInflation-Linked Bonds and Nominal Bonds Should Deliver Similar Returns in 2025<\/h2>\n