Fidelity's 2025 Fixed Income Outlook: Interest Rates Influence Investment Returns

According to Zhitong Finance APP, Fidelity has released its 2025 fixed income outlook. In 2025, the focus of the fixed income market will be on the level of U.S. interest rates at the end of the current rate cycle. Contrary to market views, Federal Reserve policymakers have a more moderate outlook on interest rates for the next two years. The market currently estimates that the terminal rate will drop to around 3.5%, but if new tariff measures are implemented, inflation is likely to rise, coupled with the expectation that the U.S. fiscal deficit will widen next year, all of which could result in the terminal rate being higher than the market's current expectations.

Most Promising Areas for 2025

Defensive U.S. Investment-Grade Bonds: Avoiding recession risks

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It has been proven that the level of the terminal rate estimated by investors often changes. For example, when the Federal Reserve cut rates by 50 basis points to 5% in September, many investors who originally expected only a 25 basis point cut were surprised, leading to an increase in the market's assessment of the terminal rate. This is because investors believe the Federal Reserve is taking early measures to address economic growth risks, thus overall, there may not be a need for significant rate cuts.

Therefore, as shown in the chart below, contrary to market views, Federal Reserve policymakers have a more moderate outlook on interest rates for the next two years.

However, other factors are also brewing.

U.S. Recession Risks Appear to Be Underestimated

When seeking opportunities in the fixed income space, investors need to be aware that the market often struggles to determine the impact of geopolitical risks and other factors, which could significantly affect economic growth.

The recent rate hike cycle has had an unusually mild impact on credit issuers. Many companies have seized the opportunity of yields being at multi-year lows to lock in lower rates for their debt and have deposited cash into short-term deposits or money market funds to earn high interest, which has actually reduced their net interest costs. Although some issuers are in distress, among the default cases up to the end of September this year, 54% have adopted the strategy of exchanging bad debt to mitigate losses for investors. However, even with lower rates locked in, issuers will ultimately need to refinance, a concern that will gradually attract the attention of investors and policymakers in 2025.

In the recent U.S. elections, exit polls showed that 68% of voters believe the U.S. economy is "not good or very poor." Regardless of how economic data appears, the American public is clearly dissatisfied with their financial situation.

If U.S. economic growth does deteriorate in the next 12 months, the Federal Reserve may be forced to cut rates more significantly than expected, resulting in a lower terminal rate. Given the current narrow credit spreads, investors may consider increasing their holdings of U.S. bonds, especially higher-quality bonds.

China: Waiting for Further Policies A major focus for next year is when China will implement and how large the scale of its stimulus measures will be. These measures may not only drive economic growth in China and the entire Asian region but could also export inflationary pressures. As Chinese authorities prepare for their next steps and consider how to respond to U.S. tariff measures (if implemented), Fidelity has assessed the situation that credit investors will face in 2025, such as:

• The Chinese real estate industry currently accounts for about 5% of the JP Morgan Asia Credit Non-Investment Grade index, down from over 30% at its peak. The index has become more robust and balanced.

• Currently, the average rating of Asian high-yield bonds is BB, and ratings may continue to be upgraded, especially in the frontier economies of Asia and the BB category, where some bonds are expected to see rating upgrades.

• The spread on Asian high-yield bonds exceeds 500 basis points, higher than the 20-year average, at an attractive level, which also means there is room for spread narrowing. Additionally, the average duration is only two years, making it less sensitive to interest rate changes.

These factors create a favorable environment for Asian high-yield bonds. If the Federal Reserve continues to ease policies, coupled with more monetary easing and stimulus measures from China, this will further benefit this asset class.

The environment for Asian investment-grade bonds is also favorable. Due to issuers' reluctance to borrow in U.S. dollars at higher rates (which are above local market rates), the supply of Asian dollar investment-grade bonds has significantly decreased, but investor demand remains high. It is expected that the U.S. dollar will strengthen in 2025, making it unlikely to reverse this trend.

Monetary Policy Outlook

In the next 12 months, fiscal spending in the U.S. and China is expected to increase significantly. The market may be excited about this prospect, but it also reflects that future growth may not be very healthy, compounded by escalating geopolitical tensions, which cast a shadow over the economic outlook.

To alleviate these concerns, Fidelity expects the Federal Reserve to take proactive measures to bring interest rates down to neutral levels. This is evident from the Fed's significant rate cuts in September, followed by a 25 basis point cut in November. However, if inflation rises, the room for further cuts may be limited. The U.S. is likely to fall into stagflation, at which point the Fed may be forced to prioritize economic growth. The European Central Bank is also concerned about high wages and service sector inflation, but the structural decline in the eurozone (especially Germany) gives investors reason to increase duration.

If the Federal Reserve cuts rates further, central banks in China, South Korea, and Indonesia can confidently continue to lower rates, providing support for Asian bonds. Conversely, if the Fed's stance is not very dovish, the Bank of Japan will have more room to normalize policy after raising rates for the first time in 17 years in March 2024.

In fact, each central bank must act at its own pace. One of the challenges fixed-income investors will face in 2025 is to keep track of each central bank's movements