Fidelity's 2025 fixed income outlook: interest rates influence return on investment

The Zhitong Finance App learned that Fidelity released its 2025 fixed income outlook. In 2025, the focus of the fixed income market is the level at which US interest rates are at the end of the current interest rate cycle. Contrary to market views, Federal Reserve policy officials are more moderate in their interest rate expectations for the next two years. The market now estimates that the final interest rate will drop to around 3.5%, but implementing new tariff measures will inevitably drive up inflation. Coupled with the expectation that the US fiscal deficit will widen next year, all of these factors may cause the final interest rate to be higher than what the market currently expects.

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As it turns out, the bottom level of the final interest rate estimated by investors changes frequently. For example, when the Federal Reserve cut interest rates by 50 basis points to 5% in September, many investors were surprised that they had expected to cut interest rates by only 25 basis points, causing the market's assessment of the final interest rate to rise instead of falling. The reason was that investors believed that the Federal Reserve took early measures to deal with economic growth risks, and overall there was no need to cut interest rates too much thereafter.

Therefore, as shown in the chart below, contrary to market views, Fed policy officials are more moderate in their interest rate expectations for the next two years.

However, there are other factors that are fermenting.

The risk of a US recession seems to be underestimated

Investors need to be careful when looking for opportunities in the fixed income sector. It is often difficult for the market to determine the impact of factors such as geopolitical risks. Obviously, these risks are likely to dampen economic growth.

The recent cycle of interest rate hikes has had an unusually mild impact on credit issuers. Many companies seize the opportunity that yields have been low for many years, lock in lower interest rates for debt, and deposit cash into short-term deposits or money market funds to earn high interest, which in turn reduces net interest costs. Although some issuers are in trouble, 54% of the default cases up to the end of September this year have used the method of exchanging bad debts to reduce losses to investors. However, even if interest rates are locked in lower, issuers will eventually need to refinance, and this issue will gradually attract the attention of investors and policy officials in 2025.

In the US election just held, export polls showed that 68% of voters thought the US economy was “not good or very bad.” Regardless of the economic data, Americans are clearly dissatisfied with their financial situation.

If US economic growth actually deteriorates over the next 12 months, the Federal Reserve may be forced to cut interest rates more drastically than expected, making the final interest rate even lower. Considering the current narrow credit spreads, investors can consider increasing their holdings of US bonds, especially higher-quality bonds.

China: Awaiting further policies

A major focus for next year is when China will implement and how large-scale stimulus measures will be introduced. These measures may not only drive economic growth in China and the entire Asian region, but may also export inflationary pressure outward. As the Chinese authorities prepare the next steps and consider how to respond to US tariff measures (if implemented), Fidelity will first assess the situation credit investors will face in 2025, such as:

• China's real estate industry currently accounts for about 5% of the JP Morgan Asia Credit Non-Investment Grade Index (JP Morgan Asia Credit Non-Investment Grade Index), down from more than 30% during the peak period. The index has become more stable and more balanced.

• Currently, the average rating of Asian high-yield bonds is BB, and the rating may continue to rise. In particular, in the Asian Frontier Economic System and BB category, there are already some bonds whose ratings are expected to rise.

• Interest spreads on Asian high-yield bonds are over 500 basis points, higher than the 20-year average. They are at an attractive level, which also means there is room for narrowing. Furthermore, since the average lifetime is only two years, it is less sensitive to changes in interest rates.

These factors have created a favorable environment for high-yield bonds in Asia. If the Federal Reserve continues to relax its policy and China introduces more monetary easing and stimulus measures, it will be more beneficial to this asset class.

The environment for investment grade bonds in Asia is also favorable. As issuers are unwilling to borrow dollars at higher interest rates (interest rates are higher than in the local market), the supply of Asian dollar investment-grade bonds has been drastically reduced, but demand from investors is still high. The US dollar is expected to strengthen in 2025, so it is unlikely that this trend will be reversed.

Monetary Policy Outlook

Over the next 12 months, US and Chinese fiscal spending should increase dramatically. The market may be happy and encouraged by this outlook, but it also reflects that future growth is actually not healthy. Coupled with the continuing escalation of geopolitical tension, the economic outlook is further overshadowed.

To address these concerns, Fidelity expects the Federal Reserve to take positive action to lower interest rates to a neutral level. This can be seen from the sharp cut of interest rates by the Federal Reserve in September and then cut interest rates by 25 basis points in November. However, if inflation picks up, the room for interest rate cuts may be limited. The US is likely to fall into stagflation, and the Federal Reserve may be forced to prioritize economic growth at that time. The ECB is also concerned about high wage and service inflation, but the Eurozone (particularly Germany) economy experienced a structural decline, which gave investors reason to increase their holdings.

If the Federal Reserve cuts interest rates further, central banks in countries such as China, South Korea, and Indonesia can rest assured that they will continue to lower interest rates, thus bringing support to Asian bonds. Conversely, if the Federal Reserve's position is less moderate, then after the Bank of Japan raised interest rates for the first time in 17 years in March 2024, there is more room to normalize policy.

In fact, central banks must act at their own pace. In 2025, one of the challenges fixed income investors face is to keep abreast of every step of the central banks.