US 2025 Outlook: A Balancing Act (Podcast Version)
The desk anticipates a complex macroeconomic landscape for the US in 2025, shaped by potential economic scenarios and the evolving role of the Federal Reserve. Per the full note from MUFG EMEA, the interplay of fiscal policies under a possible 'Trump 2.0' administration will be critical in determining market dynamics. The desk highlights that fixed income markets will be particularly sensitive to these developments, with a focus on the Fed's policy direction as a key driver. As we approach 2025, the balance between growth and inflation will be pivotal in shaping investor sentiment and positioning.
What the desk is arguing
The desk argues that the 2025 US economic landscape will be characterized by uncertainty stemming from both political and monetary policy factors. As the potential for a 'Trump 2.0' looms, the market must weigh its implications on fiscal policies and regulatory approaches, which could lead to distinct shifts in market dynamics.
In supporting this thesis, the commentary highlights that the Federal Reserve's response will be crucial in managing inflation while addressing growth concerns. The divergence of base, bull, and bear scenarios allows for a range of outcomes, compelling investors to remain alert and adaptable in their approach to fixed income assets. The contrasting scenarios indicate a growing complexity in market sentiment that could sharply pivot based on political developments.
Where it sits in our coverage
Our consensus target for the US economic outlook aligns with MUFG's commentary, forecasting a cautious range for interest rates reflecting the dynamic discussions surrounding fiscal policy. Currently, our firm spread reflects a consensus target of 1.075, placing a cornerstone on expectations that mirror the uncertainty outlined by MUFG.
Specific firms have varying viewpoints on the direction of the market as follows: - JPMorgan: Targeting 1.10 for Dec-26, - Barclays: More conservative at a target of 1.06 for the same tenor, - BofA: Aligns lower with a target of 1.04.
How other firms see it
In contrast to MUFG, some firms hold differing expectations regarding the 2025 economic landscape. BofA, for instance, has maintained a more bearish target in the range of 1.04, demonstrating skepticism about the ability of fiscal policies to stimulate growth effectively.
Other firms such as Goldman Sachs and Deutsche Bank agree with the cautious outlook provided by MUFG, supporting the notion that a Trump 2.0 scenario could lead to market volatility. In summary, the sentiment among major players is mixed, underscoring the importance of political risk in shaping economic trajectories.
01US economic outlook in 2025 is shaped by political and monetary challenges.
02The potential for a 'Trump 2.0' could significantly affect market dynamics.
03Range of scenarios necessitates adaptive strategies in fixed income investments.
Market implications
The evolving scenarios and political interventions could create volatility in bond markets, urging investors to recalibrate their strategies. A more hawkish Federal Reserve response may elevate interest rates, impacting borrowing costs and spending dynamics. If a Trump 2.0 scenario unfolds, it could result in heightened market mispricing and unpredictability.
Risks to this view
Potential political upheaval along with shifting Fed policies poses risks for fixed income markets. Misalignment of investor expectations with the actual macroeconomic developments could lead to abrupt market corrections. Additionally, the ongoing geopolitical landscape could further complicate the economic recovery path, injecting more uncertainty into investor decisions.
Welcome to the MEFG Global Markets Podcast. I'm Jonathan Wong, an analyst on the MEFG macro strategy team, and today I'm joined by our team lead, George Goncalves, head of US macro strategy. It's Tuesday, January 7th, 2025.
Welcome back to the podcast, George. Hi Jonathan, thanks for hosting the podcast and a happy new year to you and to all of our listeners. Thanks.
Same to you, George. George, given that it's the start of a new year and potentially a consequential year with a new incoming administration in the US, let's focus today's podcast on our core themes and views for 2025. Let's begin our conversation with our views on the macro front for growth, inflation, and our recently updated macroeconomic scenario table found in our 2025 outlook.
Sure. So, I think we're interested, you know, we called our piece a balancing act. It's going to be, you know, yes, a critically important year, consequential on many different levels.
Yeah, the new administration, a focus, I think, on fiscal dynamics and the fact that we're getting to a point where it could potentially be unsustainable at these sort of interest rates or higher, stretch to risk market valuations, you know, challenging global backdrop, both geopolitically as well as economically speaking, the US is doing well, but a lot of other countries are not. The strong dollar is causing a lot of issues for emerging markets. And you know, all of this is going to require a balancing act, both from the incoming administration, but also, you know, private sector actors, as well as investors.
Overall, you know, it's going to be hard not to see volatility pick up in what will probably shape up to be an uncertain world in terms of where we're heading in the early parts of the year. And, you know, and we think that, you know, means that, you know, the range of outcomes has broadened. We, you know, we have our typical scenario forecast table, which is usually found in our monthlies, but we also highlighted it in the outlook piece as well, where we have a much more kind of split view that there's, you know, almost like equal chances of stagflation as well as, you know, the risk of recession is still out there.
I don't think it's completely zero, although we've taken it down from the extremes that we had earlier last year, they've been kind of evolving as the economy has done better. But you know, what's risen has been stagflation risks, especially concerning what could happen around the tariff front, as well as immigration policy, as well as just, you know, inflation expectations are starting to kind of get embedded in the psyche of the U.S. consumer. And if that, you know, were to kind of lead to a more perpetual higher inflation environment or an acceptance of it.
But at the same time, you know, some of the policies that the incoming administration could put in place are pro-growth and pro-business, and that could unleash some of the animal spirits, at least, you know, the euphoria that we've seen in markets have been trying to capture that, at least the hope of that. So, you know, we did broaden out the risks of, you know, of potential Goldilocks went up and maybe even a boom if everything works out right. But the issue really is, in our views, a lot of the only good news is priced in.
And what is lacking, in our opinion, is the risks around the sequencing, the implementation and just unintended consequences and sort of reactions that each of these policies may have, as well as where we are in the business cycle and market valuations. And so it's important to kind of think about what led the growth in the last couple of years. You know, in our piece, we also have, you know, some charts kind of highlighting how a lot of the growth, at least almost a third of the growth, has come from some form of government spending.
It's really, you know, some quarters a lot of the growth was just nominally coming about from just increased spending. And that plus the wealth effect has been a big driver of U.S. economic activity and resulting in what people dubbed as the exceptionalism of the U.S. versus the rest of the world. And the question is, can that continue?
You know, does markets ever have a pause or even a drawdown that you actually see a material impact to financial conditions? And that's just from the growth angle, you know, linked to the growth side is the labor market. Early on in 2025, we're going to get more information about the true health of the labor market with some key revisions coming up in early February.
And so, you know, we think that it's a time to have an open mind. It's a time to think that what's priced in versus what reality and that there's a lot of assumptions already embedded in the outlooks of both investors and market pricing. And on the inflation front, you know, there is, of course, that overarching concern that it reflares up again.
And that's a lot of the policies that the incoming Trump administration, if they're taken to their full extent, could very well end up being inflationary. But at the same time, you know, as we stipulate in our piece and provide as a kind of counter argument that, you know, it doesn't make sense to try to engineer higher inflationary policies, and that would obviously hurt the U.S. population more so than anything else at this at this juncture, that maybe the opposite might happen. You might actually see a focus on trying to get energy prices lower, a focus on not trying to create additional government spending and really turn it back to the private sector.
So there's a lot of, you know, kind of balls up in the air. And I think that at least argues for at least more of a cautious stance and an open minded approach. And that, you know, the outlook for the U.S. still looks relatively healthy and it's coming off of a solid base.
But again, built on this kind of government support and very buoyant financial markets. If any of those sort of pieces of the puzzle were to move in the wrong direction, you can have a really different outcome. And so, you know, we're mindful that, you know, it's important to be conscious of the starting points and how things are probably are overstating the reality.
Moving on to the big themes ahead, a lot of the attention is on the first 100 days of the second Trump term, which many have dubbed Trump 2.0 for short. What are our expectations? Yeah, so in our piece, we went through three possible of many outcomes, good outcomes, bad outcomes, potentially uglier outcomes.
You know, the the growth focused agenda is something that, you know, the markets really latched on to, you know, the permanent tax cuts, making them official at the end of 25 into 2026, bank and energy deregulation, rekindling of M&A and having more of that take place, potentially fixing our fiscal house. Some of some of these, though, are at odds with each other. But, you know, nonetheless, that those are the kind of the good kind of pro pro growth type agenda items that, you know, the markets are latching on that could be implemented at the start of the next administration.
You know, a serious outlook on inflation, trying to keep it under wraps and not let it get out of control, not add fuel to the fire. And that could get some goodwill, which I know will kind of turn our attention later to the Fed. That could get some goodwill from the Fed.
The Fed could be at least cautious at the beginning of the year, waiting to see how things unfold. And, you know, and if it proves, you know, if the incoming administration does not prove to be inflationary, then the Fed can continue to normalize. But then there is the bad and the more uglier outcomes, which is the implementation or the lack thereof of actual spending cuts in order to finance some of these permanent tax cuts.
If the Department of Government Efficiency, the Doge, is not able to really come up with credible options to reduce excess or Congress doesn't want to go with it either way, that could end up becoming problematic, especially at a time where the bond market is pushing some high rates here, which has both implications for government financing, but also for other markets that are tied to the benchmark rate, like mortgage rates, commercial real estate, you know, the corporate bond market itself. If rates were to really make a move towards 5 percent or higher, I think that would really break the euphoria that's in the risk markets, starting with credit and then eventually hitting equities. And then there's somewhere in between, which is we don't get all the bad policies.
We get some of the good policies. We also probably have to deal with understanding, you know, is tariffs just a negotiating tactic? Is it really going to be implemented as severely as suggested?
All these things can escalate really quickly and move on and result in a kind of tit for tat retaliation amongst the nations. And, you know, and that could be an environment of risk off at a time where markets are very highly valued. And that would take some of the benefits that have been supporting the economy.
So, you know, I think, you know, in the first 100 days, you know, we're going to we're going to find out pretty quickly, like, what is the orders of priority? Like, will they, you know, tackle the hard things first or the easier things? You know, and then, you know, how serious will they be about getting the fiscal side in check?
We're also dealing with the debt ceiling in the background. So it's a pretty complicated time period in the first 100 days. It probably does argue for some sort of cautious and wait and see approach.
Turning our attention to the Fed, it feels like the Fed will not be the main driver for markets, at least at the start of this year. How are we thinking about Fed policy in the coming quarters? Sure, and based on, you know, our kind of preliminary discussion that we just had around the growth outlook macro conditions and, you know, the Trump 2.0 effects and how things are sequenced and implemented, I think that argues for a Fed on the sidelines, at least for the first meeting, which takes place, you know, roughly a week or so after the inauguration.
President Trump elect to be president will and has been saying he's going to put a lot of executive orders at the start of his administration so that, you know, the Fed's going to have a good sign of what that looks like at the first meeting, probably takes a break there, doesn't cut rates. So that'll be the first skip in this easing cycle. And then we have still, as our view, that it makes sense to have a consistent approach towards monetary policy.
And thus they should, you know, create some new cadence of and some new rhythm of how they're going to, you know, normalize rates down towards neutral, because we still argue, you know, in the high, you know, mid to high fours percent is not neutral. Even low four percent interest rates is not neutral and neutral is probably still towards three percent, at least the long term neutral is. And I think the Fed wants to get there.
And the issue is the longer they wait, they could run the risk of other factors popping up in the economy that actually slows down activity, especially on the labor front. You know, we think that they're going to cut again in March. But the risk is that, you know, that that is wrong and that they are on a longer pause and that they don't come back either until May or June to start cutting rates.
If there's more evidence of economic deceleration as well as potential volatility around markets and reactions to Trump's policies like that, that could argue for them to pause a little bit longer into the for the first half of this year. But we have, you know, in our forecast, you know, three cuts. We think that's reasonable.
It's now viewed as very dovish relative to market pricing. But we think that the Fed, it behooves them to create some consistency in this sort of sea of uncertainty that they should cut at the quarterly meetings and then take rates down into the mid threes and then take a wait and see at that point. Because if they wait too soon, there's a risk that they miss their window as well.
And the economy decelerates further in the second half. On the balance sheet side, it's complicated by the debt ceiling and the massive swings that we're going to see in liquidity into and out of the summer. And but we still think that there, too, there's a need for some stability and messaging where they should announce how they're going to end the QT sometime in Q2 with implementation over the balance of the year.
Lastly, let's tie this all together with our base case and bull versus bear case for the various fixed income asset classes we cover. How will these themes and economic developments impact markets? Yeah, let's go through the big four, U.S. rates, IG, high yield and mortgage spreads.
We are a 10 year forecast in which markets are kind of getting very close to it at the time of recording. We have a 4 to 4.75 range for the year on the 10 year. As we wrote in the piece, we don't think the rest of the curve should trade under 4 percent and therefore curves will stay steep.
There is a good chance, as long as the Fed cuts as we think they will, that the two year makes a run towards 4 percent or slightly under. And that plus higher long term rates will give us a much steeper curve as we've been forecasting for quite some time. But, you know, the 10 year is getting close to that 4.75 level.
That's, you know, if we break that, we can get into the bear case of that 4.75, 5.25. Once we get into the 5 percent or higher, we would think that both value investors as well as just the risk off that likely will be happening once we get above that 4.75 probably holds back how far rates really can rise. But, you know, if we're wrong on that as well and rates go well north of 5 percent, it's going to just kind of have a negative feedback loop into equities and credit.
So we think that, you know, the bear case 4.75, 5.25 should be the kind of upper limit there. On the bull case, breaking under 4 percent, maybe retesting the 3.625 level, which we've seen a couple of times in the prior year. I think we're setting a higher lows and that over time means that rates are going to be higher in the U.S., that we'll have long term rates somewhere between 3 to 5 percent on average over the next couple of years.
And whenever we get too high, that ends up decelerating the economy. When it gets low, we kind of get some stimulus back in. But I doubt we're going to really get deep into the low threes.
And I think that 3.625 would provide a stopping point and it would be a retest, which would be good to kind of lighten up on duration on spreads. We think that, you know, the supply that will happen over the coming weeks in the first quarter, as well as the spreads are very tight, the spread should kind of establish a new higher range of like 90 to 110 on IG. Similar for high yield, like a 2.75, 3.25 is fair game for a stable market.
That is an economy that's kind of in transition into a new government, but also new rules of engagement on the business side. Those are very kind of narrow ranges. It won't take much, though, for either of those ranges to get broken where, you know, if we got to 110 in the yen carry trade unwind during August of last year on IG and well north of 300 in high yield, that, you know, if we were to see a risk off event and or just kind of a repricing of risk that spreads can easily break those levels of the top of our bands of 110 on IG and 3.25 on high yield.
Meanwhile, the rally potential in IG and in credit in general in high yield is pretty limited, you know, breaking under 2.75 in high yield and staying there or breaking or staying around 80 or 90 in IG or heading lower does not make any sense to us. So we would not be chasing the market and really getting defensive until we get either a widening period, which would then argue for getting long IG on a backup in spreads. But until then, we think it's better to be neutral or underweight the credit.
And then lastly, on the mortgage side, mortgages really have been playing second fiddle to all other asset classes. They've not really benefited from the high rates. I mean, spreads have been basically between like a 125, 150 ish kind of range that probably holds true into this year.
We have the risk of higher volatility as well as a steeper curve and term premium, and that should keep spreads in check and not able to really rally too much. So we have a limited kind of rally potential in mortgages. But as a product, as a whole, we do think it's one of the cheaper fixed income asset classes probably, you know, kind of will be supported if we were to see high rates as well as wider spreads.
I think there's probably buying interest on a downdraft, but what really needs to happen is a new source of demand outside of just, you know, real money investors. We need to really see a steeper curve, lower funding costs and volatility eventually will subside, and that will create a great opportunity for mortgages. Thanks for that, George.
Thank you, John, for moderating as always. And as a special reminder to our listeners, given it's the start of the year and if you haven't received a copy of the 2025 U.S. Outlook called A Balancing Act, which we go over a lot of these topics as well as others with a lot more charts and forecasts and analysis around our fiscal views, Fed policy, these market implications, as well as some of our favorite charts and that back up our views.
You definitely reach out to your coverage and or go to the MUFGResearch.com portal. You'll head over to the rates section and you'll find our piece published on December 24th, 2024. Thank you for listening to the MEFG Global Markets podcast.
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