- Several structural factors are driving inflation today, including surging wages, persistent shelter inflation, higher commodity prices, and deglobalisation trends. These factors cannot be quickly and effectively controlled through high interest rates in the short term.
- Core goods inflation may rebound due to deglobalisation and could potentially become one of the main culprits behind the resurgence of inflation. Given the likelihood of further expansionary fiscal policies and still-resilient employment data, we think the US will likely achieve a soft landing.
- We expect limited room for Fed rate cuts in 2025, given ongoing risks of a resurgence in inflation. 10-year UST yields should remain at their current elevated levels, and may possibly see further upside pressure to yield levels ahead.
- The UST yield curve should continue normalising in 2025. We think short-term bonds remain attractive until we see sufficient (further) normalisation of the yield curve. Investors can consider waiting for 10y UST yields to rise to around 4.5% to 5% before considering adding duration to their portfolios.
- We prefer investment grade bonds within the corporate bonds space, given the attractive levels of absolute yields there. For high-yield bonds, we remain selective, but note several themes worth a stronger consideration, including non-AT1 bank bonds, insurance, commodity-related issuers, Japanese high-yield, Korean investment grade and Hong Kong companies/developers.
As we enter 2025, the market generally expects that the return of President Donald Trump and his policies could result in a rebound in inflation. In addition, as we have highlighted before, 10y UST yields have also risen since the first Fed cut in September, helping to confirm our views that long-end bonds were perhaps overly optimistic on the Fed’s path. Looking ahead to 2025, what are the areas in the USD bond market worth noting? What lies ahead for inflation, interest rates, and bond yields? What investment opportunities exist in the market? This article will answer this series of questions.
Cannot assert inflation is already under control
As shown in Chart 1, inflation indicators in the US have notably declined in recent months. For example, CPI and PCE in October were 2.6% YoY and 2.3% YoY respectively, approaching the Fed’s 2% inflation target. It appears on surface that the Fed has managed to successfully tame inflation from its ascent since 2021.
Chart 1: Inflation Indicators
However, referencing historical high inflation cycles (Chart 2), the Fed typically encounters twists and turns in its efforts to control inflation. We observe that during past high inflation periods, inflation often rebounded multiple times, even surpassing previous peaks - seen clearly in the two previous high inflation cycles (1940s to 1950s and 1970s to 1980s). As such, we think it is premature to assert definitively that inflation is clearly under control.
Chart 2: US CPI YoY since 1940
Surging wages and shelter inflation drive inflation figures
Several structural factors also drive inflation today, including surging wages, shelter inflation, higher commodity prices and deglobalisation. These factors cannot be quickly and effectively controlled through high interest rates in the short-term.
As shown in Chart 3, since mid-2022, services CPI has remained stubborn and been a sizeable contributor to overall CPI inflation, with wage growth being a key driver. Recent changes in non-farm payroll numbers (excluding distortions from hurricanes and Boeing strikes in October data) and unemployment rates (see Chart 4) indicate a resilient labour market. Wage growth (as shown in Chart 3) also remains at around 4% YoY, without signs of substantial declines. These factors suggest that services CPI may persist stubbornly without decreasing to a lower level.
Chart 3: Services CPI and Wage Growth
Chart 4: The Change in Nonfarm Payrolls and Unemployment Rate
Shelter inflation remains another major concern, especially as it accounts for as much as 40% of US the CPI basket. While shelter CPI (see Chart 5) appears to have decrease from a high of around 7% to 8% to a level of 4%, the Zillow Rent Index (a leading indicator for the rental portion of shelter CPI) has recently shown signs of stabilisation after a period of declines. Additionally, the US residential housing prices have repeatedly hit new highs due to insufficient supply (housing purchase costs are included in the shelter CPI calculation). These factors highlighted above could all potentially lead to a rebound in shelter CPI.
Chart 5: US Shelter CPI, Zillow Rent Index and Housing Index
Under deglobalisation, core goods inflation may return
Another factor is our higher-for-longer view on commodity prices. Since the Russia-Ukraine war broke out, relations between Western countries and the China-Russia camp have grown more tense, and we could be entering an era of deglobalisation. Amidst the increasingly volatile geopolitical situation, the supply of commodities may not flow as smoothly as before the Russia-Ukraine war, mainly because many major commodity suppliers either belong to the pro-China-Russia camp or have opted to remain neutral. These countries may not necessarily respond to calls from Western countries to increase commodity supply, and this structural issue will likely persist for a considerable period.
As an example, copper prices remain high today, constrained by limited supply. It is worth noting that the US PPI, as an indicator of price changes in goods produced by manufacturers, traditionally shows a close relationship with copper prices, often exhibiting a hand and leg dynamic. owever, this relationship came to a pause starting in 2022. We think the hand-and-leg relationship between the PPI and copper price would likely be delayed but not absent, eventually exerting pressure on the prices of end products.
Chart 6: US PPI and Copper Price
This may then explain why most countries around the world (including the US) were not significantly troubled by goods inflation from 2000 to early-2022 (Russia-Ukraine war). As shown in Chart 7, the cumulative increase in core goods prices was only 14% (and sometimes as low as 2% before 2021), while the cumulative increase in service prices surged to 109%, reflecting how globalisation historically suppressed goods inflation.
As the trend towards deglobalisation continues, countries are reshaping their supply chains, with large multinational corporations relocating production lines from China to other places to diversify their risks. The US is one such country promoting the reshoring of manufacturing. We believe that core goods inflation may return as a result in the near-term, becoming another culprit behind the resurgence of inflation.
Chart 7: Core Goods Inflation and Services Inflation
Trump’s Policies Should Not Be Primary Basis for Resurgence of Inflation
First of all, the nominee for US Treasury Secretary, Scott Bessent, proposed an ambitious "3-3-3" plan during a public meeting (refer to Table 1). His economic policies are likely to emulate the direction of former Prime Minister of Japan, Shinzo Abe's "three arrows": a dual policy of expansionary fiscal and monetary policies. He aims at driving strong economic growth, increasing disposable incomes to boost tax revenues, lowering interest rates to reduce government interest expenses, cutting unnecessary expenditures and ultimately bringing the fiscal deficit to 3% to 4% of GDP.
However, we believe that only the economic growth target (the second "3") is relatively achievable (as mentioned in the short commentary in Table 1), while the rest of the plan may likely remain as mere rhetoric.
Table 1: “3-3-3” Proposal By Scott Bessent and Our Commentary
|
|
Plan |
Our Commentary |
|
The First “3” |
Cutting the fiscal deficit to 3% of GDP by 2028, with the average fiscal deficit of 4% in four-year average (The US Congress estimated the fiscal deficit would be around 6.4% in 2024, with budget receipts of around $4.9 trillion and budget outlays of around $6.7 trillion) |
· This means the government would need to cut approximately $1 trillion in fiscal spending each year to achieve the goal, presenting an extremely challenging task. · Among current fiscal expenditures, the combined percentage of mandatory outlays, defence spending and interest payments totals up to 85%. All of these will be difficult to reduce. · Forcefully cutting certain essential expenditures could encumber economic growth. |
|
The Second “3” |
Boosting US real GDP growth to 3% each year |
· This can be driven through more expansionary fiscal policies, and we think it will not be difficult to achieve this. |
|
The Third “3” |
Increasing US energy production of additional 3 million barrels of oil equivalent per day (around 22% of the current US daily production) |
· It will be difficult to achieve this. The current WTI oil price of around $70/barrel does not provide sufficient incentives for oil companies to significantly increase their capital expenditure plans, constraining future oil supply. |
|
Source: Congressional Budget Office, Foxbusiness, iFAST compilations Data as of November 2024 |
||
We also look at new policies proposed by Donald Trump (refer to Table 2) – broadly speaking, Trump advocates an "America First" approach, and seeks to reshore manufacturing to increase job opportunities for Americans while driving domestic growth, while reducing corporate and individual taxes.
|
Topic |
Content |
Our Commentary |
|
Taxation |
· Lowering the corporate tax from 35% to 15% · Optimizing the federal tax brackets and lowering the income tax · Tax exemption on tips and social security benefits |
· This will drive corporate earnings, increase residents' disposable income and boost economic growth. |
|
Trade |
· Announced: 25% tariff on imports from Mexico and Canada and additional 10% tariff on imports from China · Proposed: 10% tariff on all imports and 60% tariff on imports from China · Seeking manufacturing reshoring |
· Tariff policies are like a "double-edged sword" as they can have negative impacts on both the U.S. and other countries' economies. · Tariffs are more likely used as bargaining chips in negotiations with other countries and may not necessarily be implemented. |
|
Semi-conductor |
· Trump believes that Taiwan has taken “almost 100%” of the semi-conductor industry from the US, and the US should charge a “protection fee” · Still maintain the CHIPS Act |
· CHIPS Act implies continued subsidies for the US semiconductor industry. However, the scale should be limited to several ten billion, thus having a limited impact. |
|
Immigration |
· Building the US-Mexico border barrier · Deporting all illegal immigrants by strengthening law enforcement |
· This could potentially compel corporates to increase wages to fill any labour shortages, but a decrease in population will certainly have a negative impact on economic growth. It is unknown whether this will actually affect the inflation rate. |
|
Monetary |
· Lowering the interest rate · Might intervene in Fed’s decisions (Powell's term ends in May 2026) |
· If President Trump intervenes to force the Fed to lower interest rates regardless of prevailing inflation trends, it could lead to a re-acceleration of inflation, possibly leading to it spiralling out of control. |
|
Source: Different Internet Sources, iFAST compilations |
||
It is worth noting that many policies and plans face various difficulties in execution, with some bordering on the realm of fantasy. Therefore, despite the current market's keen interest in factors such as Trump's policies and the appointment of the new Treasury Secretary, these factors are less important for inflation and interest rates, since there are often significant discrepancies between policies/plans and their actual execution.
Of course, we cannot deny the possibility that these new policies could indeed lead to higher inflation, but this should not be the primary basis for the case for a resurgence of inflation.
Environment of higher growth, inflation, interest rates, and bond yields, is likely to persist in 2025
Based on the considerations above, we think there is a decent likelihood of a "soft landing" for the US economy. From a policy perspective, the Government is likely to implement more expansionary fiscal policies. While employment data (such as the recent non-farm payrolls and unemployment rate) have slightly deteriorated, they are far from signalling a recession.
At the same time, to tackle massive interest payments and mandatory outlays and support economic growth, the Government has no choice but to issue more debts at a record high level and increase fiscal spending (see Chart 8), potentially leading to further deterioration of the fiscal deficit.
Chart 8: Federal Spending and Treasury Monthly Issuance
Even if Trump intervenes in the Fed’s decision-making process, forcing them to cut benchmark rates persistently, we believe the Fed still has little room to cut rates excessively due to lingering inflation risks. Additionally, considering (1) higher inflation expectations, (2) strong economic growth and (3) extensive government issuance of bonds, 10-year UST yields should remain elevated at the current level, even possibly seeing some having upside pressure to yields.
Therefore, the environment of higher growth, inflation and interest rates and bond yields is likely to persist in 2025.
Yield Curve is likely to normalise in 2025, with short-term bonds remaining attractive
The yield curve is still slightly inverted, despite having shifted lower compared to before and showing signs of flattening (see Chart 9). With markets expecting the Fed to cut one to three more times, we believe that in 2025, the yield curve will likely continue to normalise, indicating that the long-term bond yields will be higher than the short-term bond yields.
Chart 9: US Treasury Yield Curve
At current levels, we believe that long-term bond yields do not adequately reflect structural inflationary factors and term premia. If we instead make estimates using higher inflation expectations and appropriate term premia, we think there remains room for upward pressure on long-term bond yields. Therefore, currently, it is not the best time to buy long-term bonds.
Meanwhile, short-term bond yields are still relatively high and continue to be attractive when compared to that over the past 16 years (refer to Table 3). Investors can wait for the yield curve to normalise, with the 10-year bond yield rising to around 4.5% to 5% before considering investing in long-term bonds.
Table 3: Short-term Treasuries
|
Bond Name |
Tenor (years) |
Yield To Maturity |
|
0.5 |
4.2% |
|
|
1.1 |
4.3% |
|
|
1.9 |
4.2% |
|
|
Source: iFAST compilations. Data as of 16 December 2024 |
||
Prefer investment grade bonds, be selective in high-yield bonds
Turning to corporate bonds, the average yield in different markets (except for Asian high yield bonds) is still among the highest in the post-GFC era, with the average yield of investment grade bonds reaching 5% or above, higher than its historical 10-year average, suggesting attractive absolute yields compared to the past.
Chart 10: US and Asian Bond Yield (USD Bonds)
As for high-yield issuers, their credit profiles have continued to improve in 2024 so far. We expect a decrease in default rates in 2025. However, due to the low levels of credit spreads in the high-yield bond market (refer to Chart 11), there is very limited room for further spread tightening. From a valuations perspective, the high-yield bond market is not considered very attractive as a whole. Investors should therefore be selective in individual issuers and bonds when finding suitable investment opportunities.
Related article: Asian High Yield Bonds - Several hidden gems lurking in this space
Chart 11: Average Yield and Spread of Global High Yield Bonds
In terms of specific themes, there are several themes worth noting, including non-AT1 bank bonds, insurance, commodity-related issuers, Japanese high yield, Korean investment grade and Hong Kong companies/developers. Here are our selected bond ideas in Table 4 below.
Table 4: Selected USD bonds
|
Theme |
Bond Name |
Issuer / Guarantor |
Bond Credit Rating (S&P / Fitch) |
Ask Price (Investors Buy) |
Net Yield To Maturity |
|
High Investment Grade |
CK Hutchison Holdings |
A / A- |
100.3 |
4.6% |
|
|
Bayfront Infrastructure (Guarantor: Singapore Government) |
AAA / N.R |
99.7 |
4.5% |
||
|
Non-AT1 Bank Bonds |
Standard Chartered |
BBB- / BBB+ |
98.5 |
5.0% |
|
|
HSBC |
BBB / A- |
99.5 |
4.7% |
||
|
Bank of East Asia |
BBB / N.R |
101.5 |
5.5% |
||
|
Insurance |
Phoenix Group |
N.R / BBB+ |
100.4 |
5.2% |
|
|
FWD Group |
N.R / BBB- |
106.5 |
6.6% |
||
|
Chinese Issuer with International Background |
GLP China |
N.R / N.R |
91.2 |
10.5% |
|
|
Health and Happiness (H&H) International |
BB / N.R |
106.9 |
8.6% |
||
|
Fosun International |
BB- / N.R |
99.4 |
6.7% |
||
|
Hong Kong Companies / Developers |
Sun Hung Kai & Co. |
N.R / N.R |
97.4 |
6.7% |
|
|
NWS Holdings |
N.R / N.R |
91.1 |
6.5% |
||
|
New World Development |
N.R / N.R |
86.2 |
12.5% |
||
|
Commodities-related |
Murphy Oil |
BB+ / BB+ |
101.8 |
5.2% |
|
|
Vital Energy |
B / N.R |
100.8 |
7.2% |
||
|
Perenti Limited |
BB+ / BB+ |
105.5 |
5.7% |
||
|
Korean Investment Grade |
POSCO |
A- / N.R |
98.6 |
5.1% |
|
|
SK Hynix |
BBB/ BBB |
103.6 |
5.2% |
||
|
Mirae Asset Securities |
BBB / N.R |
101.0 |
5.4% |
||
|
Japanese High Yield |
Nissan Motor |
BB+ / BBB- |
98.2 |
6.0% |
|
|
Rakuten Group |
BB / N.R |
110.0 |
6.2% |
||
|
India NBFC |
Shriram Finance |
BB / BB |
101.5 |
5.9% |
|
|
Muthoot Finance |
BB / BB |
102.8 |
6.1% |
||
|
Source: iFAST compilations. Data as of 11 December 2024 |
|||||
Declaration: For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a position in CKHH 4.750% 21Apr2028 Corp (USD), BAYFIM 4.257% 16May2026 Corp (USD), STANLN 4.300% 19Feb2027 Corp (USD), HSBC 4.375% 23Nov2026 Corp (USD), FWDGHD 8.400% 05Apr2029 Corp (USD), VTLE 7.750% 31Jul2029 Corp (USD), ASLAU 7.500% 26Apr2029 Corp (USD), HYUELE 6.375% 17Jan2028 Corp (USD), RAKUTN 11.250% 15Feb2027 Corp (USD), SHFLIN 6.625% 22Apr2027 Corp (USD) and MUTHIN 7.125% 14Feb2028 Corp (USD), and the analyst who produced this report hold a NIL position in the abovementioned securities.
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