Perspectives

• The US economy remains resilient heading into 2025, buoyed by a solid job market and strong consumer spending. Core inflation has stalled above the Fed’s 2% target and is at its highest point since April.
• Rates sold off sharply across the yield curve as heightened sensitivity to inflation risks and a significant downgrade to the Fed’s projected easing path drove Treasury yields toward their 2024 highs.
• All sectors of the Bloomberg US Aggregate Bond Index posted negative returns for December. Duration was the biggest underperformer, with the 30-year Treasury returning -6.1%. In contrast, the 2-year note posted a near breakeven return.

TAXABLE BOND MARKET UPDATE & OUTLOOK

• The Fed cut rates 25 basis points (bps) as expected, but in a hawkish shift, signaled a shallower easing path moving forward. Further reductions in the fed funds rate hinge on progress around stubbornly high inflation.
• The market repriced the number of expected rate cuts by the end of 2025 from the three projected at the end of November to just under two cuts.
• Ten-year and 2-year Treasury yields rose 9 and 40 bps, respectively, sending the yield curve to its steepest level since May 2022.
• Investment grade corporates lagged the overall market and rates, given their longer duration profile and modestly wider spreads. Strong corporate fundamentals and the outsized demand for high-quality yield support a near multi-year low in spreads.
• The high yield sector was the best-performing asset class in the taxable bond market given its attractive carry and overall shorter duration. Spreads widened modestly, but at below 300 bps option-adjusted spreads remain firmly below their longer-term average. Yields at 7.5% provide an attractive equity-like return.
• Mortgage-backed securities performed in-line with the overall market. Technicals lean slightly positive with low seasonal turnover and high mortgage rates keeping originations low, providing a tailwind for the sector.
• Asset-backed securities (ABS) marginally outperformed similar duration Treasuries. Excess yield and modest spread tightening drove the outcome.
• The biggest risk to the market is if inflation stays at these higher levels, forcing a higher-for-longer strategy from monetary officials. We also see the potential for wider tail risks under the incoming administration’s fiscal policies.