The inevitable increase in interest-rate volatility is clouding the short-term outlook for the credit market.

Even before Donald Trump returned to the White House in January, bond markets had already been unsettled by the prospect. Although he is promising a “golden age”, the reality for investors is more nuanced. Investors must now contend with an environment of higher-for-longer interest rates and inflation, partly resulting from pandemic-related economic turbulence. The tariff increases, huge tax cuts and stricter immigration policies announced by Trump, if implemented, could push inflation higher, increasing the probability that the Federal Reserve might carry out only one rate cut in 2025 – or none at all – instead of the two initially expected.

Bonds: equilibrium looks a long way off

Inflation expectations mean that the yield on 2-year US Treasury notes has risen to 4.19%, while the 10-year T-note yield is now 4.53%. US stimulus plans, which are more worrying for investors in investment-grade (IG) bonds, could drive 10-year yields above 5% in the US and 2.75% in Germany, increasing the short-term risks.

The expected volatility in interest rates is continuing to limit the appeal of IG debt: current spreads are no longer sufficient to make up for fluctuations in yields, resulting in an unattractive risk/return profile. A jump in inflation, against the backdrop of a strong economy, would limit potential gains, while credit spread-tightening is no longer providing adequate protection against record volatility in yields.

In the circumstances, bond investors will have to focus on optimising coupon payments while monitoring movements in yields.

Against a backdrop of persistent inflation, hedge funds are showing a better risk/return profile than credit. Alternative strategies such as relative value (or arbitrage) could act as sensible safe havens for investors while they wait for yields to return to normal between now and the end of 2025. That process could involve lower short rates, accompanied by higher long yields.

Meanwhile, yields on IG and high-yield (HY) bonds have risen to levels not seen for two decades. On a longer-term view, this is a good reason to favour short-duration bonds in the HY market.

Solid earnings momentum for US companies

US equities started January on an optimistic note, buoyed by expectations that the Trump administration would adopt pro-business policies such as tax and regulatory reform. Such initiatives could support economic growth, with a trend rate of 2.5–2.9% possible in the next few years.

For the time being, inflation seems to be having little effect on equities, as shown by the 3.23% rise in the S&P 500. If US 10-year yields were to rise beyond 5%, this could hamper the equity rally. However, upward pressure on interest rates would not cause a major correction in equities because companies – whether or not they are tech-focused – have solid fundamentals.

A second risk relates to earnings, since expected US earnings growth has risen from 10% to 15% in 2025. If US large-caps reduce their expenditure on artificial intelligence because of uncertainty about their return on that investment, this could drag down earnings in the tech sector, with a knock-on effect across the market. However, that scenario looks unlikely in 2025, and confidence in US equities is likely to remain firm.

As earnings season begins, initial results are confirming an encouraging trend, and data regarding the health of the US economy remains positive. Margins are likely to rise in almost all sectors this year.

US mid-caps are trading at more attractive valuations than the S&P 500 while offering better quality than the smaller-cap stocks in the Russell 2000. The earnings growth of S&P 400 companies is expected to be 16% this year, slightly better than that of the S&P 500.

Conclusions regarding asset allocation

An increase in bond yields driven by inflation risks is a challenge for portfolios, because it could put pressure on credit and equities at the same time. In addition, US government measures could drive up volatility in equity indices. However, as long as the US economy maintains its growth momentum and earnings remain in line with forecasts, any market shocks are likely to be short-lived and moderate. Any corrections would therefore provide opportunities to carry out a strategic rebalancing of portfolios.

Any forecasts provided are indicative only and in no way guaranteed.