Top of the Morning: Fixed Income Strategist - A bumpy ride into 2025
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Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today, we will continue with our ongoing series of fixed income conversations as we will spend some time outlining an outlook for the asset class here in 2025. Our conversation will tie right into the recent Fixed Income Strategist Public

from the UBS Chief Investment Office. Title is A Bumpy Ride Into 2025. Joining me here today for the conversation, glad to welcome back the publication's lead author, Leslie Falconeo, head of taxable fixed income strategy for the Americas. So with that, Leslie, thank you for dropping by, spending some time today with our listeners and their clients. Looking forward to our conversation. Welcome back. Thank you, Dan. I appreciate it.

So, Leslie, we concluded 2024 with yields on the rise. What are your thoughts on this investor demand trend for higher yields as we do see yields climbing higher here in the early days of 2025? Yeah, well, I mean, listen, there's no question. I mean, we've seen a

very large move, just not in terms of 2025, but as we've written about since the September 50 basis points cut by the Fed, you've had this large dislocation with the Fed cutting and interest rates rising, particularly, and

I don't want to say solely, but really mostly in that back end of the curve. And as we know, we've been very cautious on that back end for quite some time, partly because of the fact that we knew that a newer red sweep would lead to supply concerns, to deficit concerns, to potential inflationary concerns when it comes to tariffs, and also possibly

some pro-growth in terms of fiscal stimulus. But we've seen this big rise, particularly in the back end of the yield curve. And partly it has been, there's no question, like when we look at Friday's employment report of 256, that was much greater than what was expected. It's January. These numbers do have a tendency to be revised lower.

But what's really happening is the market or fixed income investors are really just staying a little bit sidelined until they get more of a clear picture of what the rhetoric is going to be versus actual implementation. And I think a lot of these rising yields, it's not just U.S. focus, it's been really happening globally.

But we do think that at these levels, and one of the things that we talked about, Dan, within the fixed income strategist, why we labeled it bumpy ride into 2025, that while we still think yields are going to trend lower throughout the year, it's definitely not going to be a straight line. You have a lot of headline risk going through. You're going to have some base effects in terms of the inflation in the beginning of the year.

But overall, our view is that, you know, we do trend lower and we do believe still that the Fed will cut 50 basis points this year in June and September, although obviously that is, you know, half of what we thought started entering the year. So if we focus in a bit further on the Fed, Leslie, with 100 basis points of Fed rate cuts behind us in 2024, as we look ahead, what's

what are your expectations for monetary policy here in 2025? Yeah. I mean, there was a lot, you know, the market has really shifted sentiment and most strategists have, you know,

shifted to the hawkish side, particularly after that employment report. I mean, those that were anticipating four cuts are now two cuts. Those that were anticipating a start in March are now moving it to the second half of 2025. So the market has really recalibrated in terms of what's priced in for the Fed for 2025. As a matter of fact, just this morning when I looked, it said 19 basis points

of cuts priced in throughout all of 2025, which is not expected to occur until December of this year, so December 2025. And not only that, but the market's saying, okay, you may even, if, do one cut, and then you're going to stay there. So meaning that what we call the terminal rate is remaining very elevated.

Now, as we know, I mean, listen, the economy is strong. There's no question about it. The consumer is resilient. But that real effective fund rate is still very high. So we think it's a little bit premature now.

to go that hawkish to where we remove all cuts in 2025. So our expectation still remains that we get two cuts in June and in September, totaling 50 basis points. But we have a little bit, what people forget is it's just January, right?

We have a lot of data from now to the end of the year. We have a lot of compositions that are going to change from now to the end of the year. We're going to have more clarity on policy implementation. But the market is really front-running in this a lot that has really pushed up yields, particularly that back-end. And part of that back-end rise is because of the removal of

of the December 2025 Fed Fund contract, which was once 150 base points of cuts, then 100 base points of cuts. Now it's less than one. So that does influence the 10-year Treasury. But on top of that, we also have some investors concerned about supply. Yes, growth and inflation are part of that picture. But what we've really seen when you look at things like the GDP now –

although strong at 2.6%, it used to be 3.3%. So there's a lot of sort of various influence here. I think it's mostly because people are just on the sidelines now waiting to see what kind of policies are truly going to be implemented versus just speculated. Leslie, to single out fixed income spread compression, can you speak a bit to what you've been picking up on there? And then further, can you share with us your views on cash? Yeah, I mean, listen, I think the credit markets are really the key here because we talk about...

rising real yield, which is things like the nominal minus inflation expectations. And, you know, when you look at real yields, like the 10-year tip, for example, it's like a 233, right? When real yields rise, right, it can be restrictive. So financial conditions start to tighten. And we have obviously seen some correction within the equity market since the election and since the beginning of the year.

but the key component to financial conditions or financial conditions you know typing to point where it is a concern to the market is credit and at the end of the day we're just not seeing a lot of spread providing on the credit side me both high-yield and invest in great corporate yes might be a handful wider but they've actually stayed very contained

in terms of spread volatility, in terms of interest rate volatility, which is really keeping, while financial conditions are tighter, they're not really overly tightening because the credit market is still wide open. Now, there's no question that could shift. And as a matter of fact, our point of view is that

We had mentioned in the strategist that even though we think interest rates could turn lower in 2025, it wasn't going to be a straight line. You definitely had the ability to see that October 2023 high of 501% just given the fact that people are sidelined and they don't know what policy implementation is going to be.

But to move over that in a sustainable fashion, in our opinion, is going to hit that credit market. Whether it's growth or inflation that pushes that back end higher, at these level of rates, I think it's going to be a bit of a problem for credit, which we haven't seen. So the credit market, we still like IG corporates. There are about 80 off and spreads. They're not cheap by any stretch, but given the fact that we are –

in an environment where there is a lot of unknowns. We like that higher quality for the IG corporate side. And we're also taking our credit exposure in that floating rate side, meaning senior loans. One, because relative to other sectors, senior loans are cheaper than high yield. And two, because we implemented this in December,

that a good sort of diversification to our long the five-year and being long IG and agency MBS, all high quality, is this floating rate sector if, in fact, the Fed did not cut as much we anticipated. And lo and behold, I mean, we've shifted our cuts from 100 basis points to 50 basis points, and the market's even gotten more hawkish.

So you're getting a lot of carry in terms of that floating rate asset. But I think that credit part right now, it's held in well, but it's really going to be the key to watch because that's going to be the snowball in terms of what happens with financial conditions and how the equity market's impacted.

With respect to positioning, if we look across the asset class, where at the moment are you finding pockets of vulnerability and opportunity? Anything in the way of positioning you'd like to reinforce for our listeners and clients? Yes, the pockets of vulnerability are really those that are...

An inflation re-acceleration, and when I say inflation re-acceleration, I'm not talking about sticky inflation lasting longer than what people projected and therefore we're at 2.7, we're not at 2.0 at the Fed's target. I'm talking about an actual re-acceleration of inflation that you see through such things as

hourly earnings or wage growth or something happens with the commodity market, that kind of re-acceleration of inflation for a longer period of time would have a negative impact. It would have a negative impact on interest rates moving up. It would also have a negative impact on credit spreads that while we believe are important

stay within the range, that would be definitely a headwind to return because spreads would widen out quite a bit given the fact that they are at tighter levels. Dan, you talked about the cash side. One of the differences heading into 2025 versus 2024 is that the Fed did cut 100 basis points. The yield and the income that you're earning on cash

heading into this year versus last is 100 plus basis points lower. And remember, we think that the Fed's going to cut twice this year. So it's even going to, you still have that reinvestment risk. So unless you have a really large rise in rates, sustainable growth,

Then we think that the total return is really going to be about compounding income. And we showed in the fixed income strategist, one was these break-even spreads and break-even yields that investors have as a cushion, which are quite ample.

And the second we showed our projected total returns as the five-year and 10-year shift on different points. So we have the 10-year going all the way up to, say, 520 and staying there. And even in IG at that point,

you know, would have a positive total return simply by the income, right? Same with the U.S. Treasury. Now, if we get to that, you know, vulnerability where inflation re-accelerates by, you know, something that we're not expecting, and you have 10-year Treasury yields go to 5.5% and stay there, right?

then the income that you're earning might be a bit of a headwind in terms of having a positive total return. But our premise is if that were to occur, then more than likely the equity market, which is also fully valued, would probably start to feel some pressure and people would shift back into fixed income again. So that's why we're not looking at necessarily where you could reach, although we think –

of 5% is where you're going to go, and you're not going to go much greater than that with what we know right now. And that's why we just don't think it's going to be something that's sustainable. So we're actually looking to increase our interest rate exposure because we have been very adamant about not taking on interest rate risk in the back end of the curve. And what I mean by that is like seven years out, we've kept our interest rate risk and

You know, in that more in that short end, getting earning that income, having that kind of protection without going a little bit too far over our skis, given the uncertainty. When you have a market that's pricing in such a hawkish outlook, when you have such speculation about policy implementation without even knowing what's actually going to go through, you know, we've had these it.

yields rise. So now we have a time that we're looking at, you know, at around 5%. We would take that short end and start to extend a bit further back because we think that over time that growth continues to decline but remain above trends. We believe that inflation starts to come down by the end of the year. That doesn't mean that you're not going to have like some base effects that we're going to see in the first quarter of this year, which the market's expecting.

that inflation might stay flat or even slightly go up a little bit, but start to trend down the second half. So that's really our positioning right now. So we've had interest rate risk in the short end. We've kept it with higher quality. We added to floating rate in December to not only earn incremental income, but also, too, as a bit of a diversification if, in fact, the Fed was not as diversified.

dovish and turn off the markets pricing and that they won't be. So that's really been our combination in terms of how we think play out going forward. Well, Leslie, very productive conversation. Thank you for dropping by top of the morning to share with us your outlook for fixed income here in 2025.

hitting on some of these near-term market trends and, of course, the guidance when it comes to positioning. So thank you again for your time today, Leslie, and do look forward to picking back up with the conversation again soon. Thanks, Dan. I appreciate it. Again, today we've been joined by Leslie Falconeo, head of taxable fixed income strategy for the Americas with

the UBS Chief Investment Office. We have been making reference to the Fixed Income Strategist publication, a title for January, A Bumpy Ride Into 2025. For clients of UBS, please reach out to your UBS financial advisor if you would like to receive a copy of the publication directly. The publication can now also be located up on ubs.com forward slash CIO. From UBS Studios, I'm Dan Cassidy. Thank you for joining us.

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