2025 fixed-income outlook: getting ahead of a steepening yield curve

The fixed-income market currently presents an intriguing paradox: yields remain historically high, even as the U.S. Federal Reserve embraces a more accommodative monetary policy. What does this mean for investors?

Entering 2025, fixed-income yields remain at historically elevated levels, a somewhat counterintuitive trend given the U.S. Federal Reserve's (Fed) shift toward easing that began in September 2024. While the Fed's path forward will depend on how the economic data continues to evolve, we expect that the central bank will maintain its approach of easing monetary conditions throughout the year.  As a result, we also expect yields on cash and money market instruments to continue to trend downward, even if longer-term interest rates remain elevated.
 

Money market yields have declined over the past year

Yield (%)

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Source: Bloomberg, as of December 31, 2024. See disclosure for index definitions. It is not possible to invest in an index. Past performance does not guarantee future results.
 

Over the past year, the yield on the U.S. 3-month Treasury bill has declined from 5.33% at the end of 2023 to 4.28% at the end of 2024. Meanwhile, the Bloomberg U.S. Aggregate Bond Index yield ended the year slightly higher than where it started. For investors focusing on cash and short duration strategies, this environment highlights the importance of effectively managing reinvestment risk.

How will interest rates shift in the coming year?

With yields currently sitting at the high end of recent ranges, and the market adjusting its expectations by pricing out many of the Fed rate cuts that were previously anticipated, this environment presents a potentially attractive entry point for investors considering adding duration to their portfolios. This view is supported by our belief that the fixed-income landscape continues to offer a positive outlook for total return due to persistently higher yields.

Our base case scenario is one in which rates and spreads remain rangebound, leading to yields in the fixed-income market closely aligning with expected returns. However, we see two additional scenarios that could lead to further steepening of the yield curve. In a bullish scenario, a broad rally in yields could generate additional positive total return in addition to the yield. A bearish scenario, where yields push even higher, would weigh on performance, but elevated yields could provide a buffer, helping to protect against negative total returns.
 

Elevated yields have created an asymmetric return profile

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Source: FactSet, Inc., as of December 31, 2024. This is for illustrative purposes only. This table shows hypothetical performance, assuming there are no spread changes across the U.S. Treasury bond yield curve, holding the yield curve constant. Shading from red to green indicates the degree of negative to positive returns. No forecasts are guaranteed. See disclosure for index definitions. It is not possible to invest in an index. Past performance does not guarantee future results.
 

What's next for the Fed?

At the December meeting, the Fed continued to ease policy, cutting its benchmark interest rate by 25 basis points; however, the central bank also signaled that it would be taking a cautious approach in 2025. This shift in rhetoric comes amid strong economic data and inflation that remains elevated above the target range. Additionally, potential changes in government policies concerning tariffs and deregulation add another layer of uncertainty regarding the future path of monetary policy.

Looking ahead, we do anticipate further steepening of the yield curve under several potential scenarios. In the event of a soft landing or no landing, we would expect to see short-term interest rates decline while longer-term yields remain stable, hovering near current levels. On the other hand, if the economy experiences a hard landing, we expect to see a broader decline in yields across the curve. This scenario would also necessitate more aggressive action from the Fed to reduce short-term rates to stabilize the economy and soothe financial markets.

Where are we seeing opportunities in fixed income?

We’ve long believed that remaining duration neutral while strategically taking advantage of changes in the shape of the yield curve can offer a reliable and repeatable way to generate alpha within fixed income. This is particularly true if rate volatility continues throughout 2025, as we expect. While it’s impossible to predict exactly what the Fed might do in the months ahead, we believe that intermediate-term bonds are well positioned for the current market environment, typically outperforming both short- and long-term bonds during such periods.

Given the uncertainty around whether the Fed will be able to achieve a soft landing, we still believe that defensive positioning remains the most prudent option at this time; however, finding incremental yield will be essential as carry will play a crucial role in performance in the near term. With valuations approaching or even exceeding historical highs across most sectors, this presents the prime environment for active management to excel, with the potential to find valuable opportunities through rigorous, bottom-up analysis.

In line with this defensive stance, we currently favor agency mortgage-backed securities due to their liquidity and attractive relative value compared to corporate credit. Within this part of the market, active management is essential if interest rates do begin to fall, allowing for effective mitigation of prepayment risk while still targeting elevated yields. Within corporate credit, we see value within intermediate maturities and are focusing on opportunities within the financials and utilities sectors.

Navigating an uncertain bond market with active management

Much like in recent years, we believe that bond market volatility will likely persist until there is a clearer path forward for both the Fed and the broader economy. However, this doesn’t mean that investors should stay on the sidelines. By doing so, they risk missing out on the attractive entry point currently offered by elevated yields and an economy that has remained surprisingly resilient so far. In this environment, active management has an opportunity to prove its mettle, guiding investors through uncertain times and helping them capitalize on available opportunities without taking on excessive risk.

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The Bloomberg U.S Aggregate Bond Index tracks the performance of U.S. investment grade bonds in government, asset-backed, and corporate debt markets. It is not possible to invest directly in an index. A yield curve illustrates the relationship between interest rates and the maturity dates of government debt securities, used as a tool for predicting economic trends and future interest rate changes. Duration measures the sensitivity of the price of bonds to a change in interest rates.

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