2025 USD Bond Market Outlook: With Resurgence of Inflation, Bond Yields will Remain Elevated

Highlights:

• Several structural factors are driving inflation, including surging wages, shelter inflation, higher commodity prices and deglobalisation. These factors cannot be quickly and effectively controlled through the high interest rate in the short term.

• Under de-globalization, the core goods inflation may return as a result, becoming one of the main culprits behind the resurgence of inflation. Since the US Government is likely to implement more expansionary fiscal policies, and the employment data are still far from a recession, we believe that US is likely to achieve a "soft-landing" scenario.

• Due to the risk of resurgence of inflation, we believe that the Fed's room for interest rate cuts in 2025 will be very limited, resulting in a higher for longer view in the interest rate. The 10-year bond yield should remain elevated at the current level, even possibly having upside pressure. The environment of higher growth, higher inflation and higher interest rate and bond yields is likely to persist in 2025.

• The yield curve is likely to be normalised in 2025. The short-term bonds remain attractive. Investors can wait for the yield curve to be normalised, with the 10-year bond yield rising to around 4.5% to 5% before considering investing in long-term bonds.

• In terms of corporate bonds, we prefer investment grade bonds. From an absolute yield perspective, this level of yield is attractive. Given the low credit spread in the high yield market, we remain selective in this space. Within the corporate bonds, there are several themes worth noting, including non-AT1 bank bonds, insurance, commodity-related issuers, Japanese high yield, Korean investment grade and Hong Kong companies/developers.

As we enter 2025, the market generally expects that with the return of President Donald Trump, inflation is likely to rebound due to Trump’s policies. In fact, as we emphasized earlier in the year that the "Interest Rate and Bond Yields will Stay Higher for Longer" (related article), although the Fed began cutting rates in September, the 10-year treasury yield is increasing instead of falling since the rate cuts. It confirms that our views were largely correct. Looking ahead to 2025, what are the areas in the USD bond market worth noting? What lies ahead for inflation, interest rates, and bond yields? What investment opportunities exist in the market? This article will answer this series of questions.

Cannot Assert Inflation is Already Under Control

As shown in Chart 1, the inflation indicators in the US have notably declined. For example, CPI and PCE in October were 2.6% YoY and 2.3% YoY respectively, approaching the Fed’s 2% inflation target. Seemingly, the Fed successfully managed the high inflation since 2021.

Chart 1: Inflation Indicators

However, referencing the historical high inflation cycles (see Chart 2), the Fed typically encounters twists and turns in its efforts to control inflation. During past high inflation periods, inflation often rebounded multiple times, even surpassing previous peaks, as seen in the two previous high inflation cycles (1940s to 1950s and 1970s to 1980s). Whether the inflation is under control remains uncertain, and we cannot assert the inflation is already under control.

Chart 2: US CPI YoY since 1940

Surging Wages and Shelter Inflation Drive Inflation Number

In the current macroeconomic environment, we believe that several structural factors are driving inflation, including surging wages, shelter inflation, higher commodity prices and deglobalisation. These factors cannot be quickly and effectively controlled through the high interest rate in the short term.

As shown in Chart 3, since mid-2022, the services CPI remained stubborn and has been a contributor to the overall CPI increase, with wage growth being a key driver of inflation within the services CPI. The change in non-farm payroll numbers (excluding distortions from hurricanes and Boeing strike in October data) and the unemployment rate (see Chart 4) indicate a resilient labour market. The current wage growth (as shown in Chart 3) is still at around 4% YoY, without signs of further decline. These factors suggest that the services CPI is likely to persist stubbornly and may not decrease to a lower level.

Chart 3: Services CPI and Wage Growth

Chart 4: The Change in Nonfarm Payrolls and Unemployment Rate

Furthermore, the shelter inflation remains a major concern, accounting for as much as 30% to 40% of the US CPI or core CPI components. While shelter CPI (see Chart 5) appears to decrease from a high of around 7% to 8% to a level of 4%, the Zillow Rent Index (a leading indicator for the rental portion of shelter CPI) showed signs of stabilization after a period of decline. Additionally, the US residential housing prices repeatedly hit new highs due to insufficient supply (housing purchase costs are included in the shelter CPI calculation), which are potential factors that could lead to a rebound in shelter CPI.

Chart 5: US Shelter CPI, Zillow Rent Index and Housing Index

Under De-globalisation, Core Goods Inflation may Return

Another factor is the higher for longer view on commodity prices. Since the Russia-Ukraine war broke out, the relations between Western countries and the China-Russia camp become tense, entering a backdrop of de-globalisation. Amid the increasingly volatile geopolitical situation, the supply of commodities may not flow as smoothly as before the Russia-Ukraine war, mainly because many major commodity-supplying countries belong to the pro-China-Russia camp or are neutral. These countries may not necessarily respond to calls from Western countries to increase commodity supplies, and this structural issue is likely to persist for a considerable period.

Taking copper as an example, constrained by limited supply, the copper price remains high. It is worth noting that the US PPI, as an indicator of price changes in goods produced by manufacturers, traditionally shows a close relationship with copper prices, often exhibiting a lend and leg dynamic.

However, this relationship came to a pause starting in 2022. Copper is widely used in construction materials, raw materials and the real estate industry, so we believe that higher copper prices will eventually drive the US PPI. The lend and leg relationship between the PPI and copper price would likely be delayed but not absent, exerting pressure on the prices of end products.

Chart 6: US PPI and Copper Price

This extends to explain why most countries around the world (including the US) were not significantly troubled by inflation from 2000 to pre-2022 Russia-Ukraine war. As shown in Chart 7, the cumulative increase in core goods inflation was only 14% (and sometimes as low as 2% before 2021), while the cumulative increase in service inflation surged to 109%, reflecting how globalization historically suppressed goods inflation.

As the trend towards de-globalization continues, countries are reshaping their supply chains, with large multinational corporations relocating production lines from China to other places to diversify risks. The US is promoting the reshoring of manufacturing. We believe that core goods inflation may return as a result, becoming one of the main culprits behind the resurgence of inflation.

Chart 7: Core Goods Inflation and Services Inflation

Trump’s Policies Should Not Be Primary Basis for Resurgence of Inflation

First of all, the nominee for US Treasury Secretary, Scott Bessent, proposed an ambitious "3-3-3" plan during a public meeting (refer to Table 1). His economic policies are likely to emulate the direction of former Prime Minister of Japan, Shinzo Abe's "three arrows": a dual policy of expansionary fiscal and monetary policies. He aims at driving strong economic growth, increasing disposable incomes to boost tax revenues, lowering interest rates to reduce government interest expenses, cutting unnecessary expenditures and ultimately bringing the fiscal deficit to 3% to 4% of GDP.

However, we believe that only the economic growth target (the second "3") is relatively achievable (as mentioned in the short commentary in Table 1), while the rest of the plan may likely remain as mere rhetoric.

Table 1: “3-3-3” Proposal By Scott Bessent and Our Commentary

Besides, combining with the new policies proposed by Donald Trump (refer to Table 2), Trump advocates "America First", reducing corporate and individual taxes and seeking manufacturing reshoring to increase job opportunities for Americans and drive the US economic growth.

Table 2: Trump’s Policies

It is worth noting that many policies and plans face various difficulties in execution, with some bordering on the realm of fantasy. Therefore, despite the current market's keen interest in factors such as Trump's policies and the appointment of the new Treasury Secretary, these factors are less important for inflation and interest rates, since there are often significant discrepancies between policies/plans and their actual execution.

Of course, we cannot deny the possibility that these new policies could indeed lead to higher inflation, but this should not be the primary basis for resurgence of inflation.

The Environment of Higher Growth, Higher Inflation and Higher Interest Rate and Bond Yields is Likely to Persist in 2025

From the above considerations, there is a higher likelihood of a "soft landing" for the US economy. From a policy perspective, the Government is likely to implement more expansionary fiscal policies. The employment data (such as the recent non-farm payrolls and unemployment rate) slightly deteriorated, but are still far from a recession.

At the same time, to tackle massive interest payments and mandatory outlays and support economic growth, the Government has no choice but to issue more debts at a record high level and increase fiscal spending (see Chart 8), potentially leading to further deterioration of the fiscal deficit.

Chart 8: Federal Spending and Treasury Monthly Issuance

Even if Trump may intervene in Fed’s decision, enforcing them to cut the benchmark rate persistently, due to the risk of resurgence of inflation, we believe that the Fed's room for interest rate cuts in 2025 will be very limited, resulting in a higher for longer view in the interest rate. Additionally, considering (1) higher inflation expectations, (2) strong economic growth and (3) extensive government issuance of bonds, the 10-year bond yield should remain elevated at the current level, even possibly having upside pressure.

Therefore, the environment of higher growth, higher inflation and higher interest rate and bond yields is likely to persist in 2025.

Yield Curve is Likely to be Normalised in 2025, with Short-term Bonds Being Attractive

The yield curve is currently still inverted, having shifted lower compared to before, and showing signs of flattening (see Chart 9). With the Fed’s rate cut for one to three more times, we believe that in 2025, the yield curve is likely to be normalised, indicating that the long-term bond yields will be higher than the short-term bond yields.

Chart 9: US Treasury Yield Curve

At the current levels, we believe that long-term bond yields do not reflect the structural inflationary factors and term premiums. If we estimate with higher inflation expectations and appropriate term premiums, there is still upward pressure on long-term bond yields. Therefore, currently, it is not the best time to buy long-term bonds.

The short-term bond yields are still relatively high, continuing to be attractive over the past 16 years (refer to Table 3). Investors can wait for the yield curve to be normalised, with the 10-year bond yield rising to around 4.5% to 5% before considering investing in long-term bonds.

Table 3: Short-term Treasuries in FSMOne

Prefer Investment Grade Bonds, Be Selective in High Yield Bonds

About the corporate bonds, the average yield in different markets (except for Asian high yield bonds) is still the highest in the post-GFC period, with the average yield of investment-grade bonds reaching 5% or above, higher than past 10-year average. From an absolute yield perspective, this level of yield is attractive.

Chart 10: US and Asian Bond Yield (USD Bonds)