Trump's agenda of higher tariffs, tax cuts, and stricter immigration measures could, if actually implemented, spur inflationary pressures, thus curbing the momentum for interest rate cuts. This ‘higher-for-longer’ interest rate environment favours hedge funds over fixed income investments – an asset class we have downgraded from 3/5 to 2/5.
Key Takeaways
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Hedge funds provide a better risk/ reward profile than fixed income assets in a ‘higher-for-longer’ inflationary environment.
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Despite the rising yield environment, the outlook on equities is moderately positive, as earnings will accelerate across most sectors in 2025.
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Gold remains a strong conviction for 2025 given a sustained inflation backdrop.
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The US technology sector and domestic US mid-caps remain our preferred segments in global equities at the start of the year.
Editorial
Momentum slows on rate cuts
The policies of the incoming US administration are beginning to challenge the fixed income market. Trump’s agenda on higher tariffs, tax cuts, and stricter immigration measures could spur inflationary pressures if implemented. These uncertainties increase the likelihood of just one Federal Reserve rate cut – or none at all –, while our scenario forecasts two reductions in 2025. In this environment, the current tight spread levels offer insufficient protection against interest rate volatility, creating a precarious risk-return balance, with the potential for yield overshoots as they near elevated levels.
With this in mind, our tactical view on fixed income has turned bearish. Upside risks to US inflation in a robust economy are likely to limit capital gains, while narrow spreads offer little protection against rising yields. To navigate these challenges, hedge fund strategies may serve as a haven until interest rate risks normalise later in the year. Despite this short-term caution, our long-term outlook on fixed income remains unchanged: the sustained high level of carry is still attractive for those investors with an extended time horizon, and who are willing to weather transient interest rate volatility.
On the equity front, our outlook for US equities remains positive, underpinned by solid earnings growth. Although rising yields may present challenges in the near future, robust fundamentals continue to support valuations across both technology and non-technology sectors. This market stands out as a resilient option, particularly in a fragmented global economic landscape.
Strategy
New year starts with interest rate risk
As 2025 begins, US 10-year Treasury yields have broken above 4.5% for the third time in the post-pandemic era. During the episodes in autumn 2023 and in spring 2024, the stability of the US Treasury markets was challenged with meaningful volatility, enough so that US policymakers pivoted in an effort to restore order to markets.
This third episode in 2025 poses a different test for policymakers than the previous two. During 2023 and 2024, US authorities could rely on the tailwind of falling inflation to aid in their efforts, as this provided a backdrop against which US policy communications and then actual policy rates could pivot in an attempt to re-anchor longer-term yields to a lower level.
This time, however, US inflation, as well as recent inflation prints in the UK, Germany, and Japan, have surprised on the upside and have concerned markets over the stickiness of prices following their declines through much of 2023/24, likely bringing the Fed to pause its rate-cutting cycle at least temporarily in early 2025.
Indeed, amidst this inflation ambiguity, the Fed’s own December dot plot has already removed the expectation that the Fed would cut rates to 3% by the end of 2025 and instead suggests a terminal rate closer to 4%, i.e. only slightly below current levels, by year-end.
For US dollar bond investors in particular, this suggests that the normalisation of the American yield curve under way since 2023 should continue. With 2-year yields likely floored at near 4% according to both the Fed’s guidance and UBP’s forecast, a return to the pre-pandemic 1989–2019 average of 110 bps would mean US 10-year Treasury yields of just above our 2025 target of 5%, as outlined in our 2025 Investment Outlook.
Despite the compensation investors earn for buying longer-dated bonds becoming positive once again, it would still take a move towards 5.5% for this 10-year ‘term premium’ to normalise to its 1989–2019 average.
This normalisation process which has been unfolding since the Fed rate-hiking cycle ended in 2023 – across not only USD, but also GBP, EUR and JPY bond markets – is coming under further pressure from the leadership transition taking place in late January as Donald Trump takes office.
With he and his transition team remaining tight-lipped about details surrounding tax, immigration, and tariff policies, the risk exists that a fiscal shock may emerge – not unlike that seen in the UK under the short-lived Truss government in 2022 or even in the US in 1980 under Ronald Reagan.
This, combined with the fiscal position left by the outgoing Biden administration, where the US budget deficit in October/November has already reached USD 650 billion (up 67% year-on-year), suggests that tail risks exist for even higher yields than our 5% target for 2025 captures.
As a result, for fixed income-focused investors, we continue to prefer low-to-no-duration credit strategies. For bond-heavy, multi-asset investors, however, we continue to believe select fixed income alternative hedge fund strategies offer a valuable refuge until the interest rate risk fully normalises over the course of the year.
