Fixed Income Outlook
The Search for Neutral
The world of investments is littered with unusual terminology and curious concepts. There are wonderful sounding terms such as the ‘efficient markets hypothesis’ or the ‘capital asset pricing model’ but they are for another day. In 2025, we have a different one to contemplate: the ‘neutral rate’. A key question for bond investors is what the level of the neutral rate is since this will be a key driver of returns in the coming years.
Now that inflation has come down from its highs, central banks are beginning to cut interest rates in developed markets. The question is where do they stop? That will ultimately determine what returns investors get on cash investments and ultimately drives bond returns.
We have a positive view on the growth outlook, but in the event of a growth shock central banks could now cut base rates aggressively. Hence, bonds would be in a strong position to play the traditional hedging role in a multi-asset portfolio.
What is the Neutral Rate?
In theory, it is the short-term interest rate that neither stimulates nor restricts the economy. This rate can and does change over time which makes it even harder to measure. It drives lots of discussions at central banks and is a hot topic for many economists and bond investors. The neutral rate becomes a guide for central bankers and markets. If the economy slows, then they cut rates below the neutral rate. If inflation is high, they need to raise interest rates above the neutral rate to help get inflation back under control. All this happens without truly knowing what the number is. Quite the challenge indeed!
Some of the factors that are suspected to impact the neutral rate are:
• Economic growth potential
• Demographics
• Inflation
• Monetary policy tools such as quantitative easing
Why Focus on the Neutral Rate?
There are many factors that go into thinking about bond returns, so why do we suggest that the neutral rate is the key one to consider for 2025? Well inflation has come down significantly, so that appears under control. Secondly credit spreads are tight, so investors do not get much extra compensation for taking extra risk. That means there is limited chance for riskier fixed income to materially outperform. A positive growth backdrop will likely mean modest extra returns from the credit and EM asset classes, but it will not be the key driver.
What Does it Mean for Returns?
When we buy a bond, we know the return we will get if we own it until it matures and the borrower pays us back. If we buy a 10-year bond at a 4% yield, we will get a 4% return. This makes bond investing straightforward in many ways as long as you do not have to do anything for 10 years.
It is when we think about how bonds will perform over shorter periods that the neutral rate can be important. One scenario relevant today is that in Europe where markets have a low growth outlook due to the potential impact of policies under the Trump administration. This means that the neutral rate may be lower than we think today. In this case, the bond referenced above might be trading with a 3% yield. This leads to a potential for significant capital gains of around 8% in this case of this bond. When you add that to the income return of 4%, this results in very strong overall returns of around 12%. Conversely, if the neutral rate is higher than markets suspect it can go the other way, and you will see losses. The US has been a case in point here recently as yields have risen given the strong growth and inflationary environment expected in 2025.
This concept of neutral becomes more important when growth is going along reasonably nicely, and the risks of a recession (normally great for bonds) and rising or high inflation (normally terrible for bonds) are not the base case. That is the world we are thinking of in 2025.
How Far from Neutral?
As we discussed earlier, different factors can impact the neutral rate. In Europe where the structural growth outlook is quite challenged, this could lead the ECB to cut slightly below neutral. Additional challenges of proposed US tariffs from the incoming US administration could necessitate further rate reductions. Overall, we see the ECB cutting to a greater extent than priced by markets currently, which would support bond returns.
The US is in a better starting position from a growth perspective. Further support for growth could come from a deregulation across many industries and lower taxes. At the same time, tariffs could increase US inflation. As long as growth remains solid and inflation is under control, however, we still think the neutral rate is below where current pricing is and that the Fed will ultimately use this room to support growth by continuing to cut rates. Again, this would be supportive of positive bond returns.
ILIM Outlook 2025 - Fixed Income
