Priced in rate hikes "too much, too soon"
James Bilson, Fixed Income Strategist, Global Unconstrained Fixed Income, Schroders, explains why, although a wave of renewed rate-hike pricing across major economies has pushed yields higher, in our view the move has gone too far. As a soft landing becomes more likely, these dislocations are opening up attractive entry points.
Although the US remains the main input into global financial markets, over the past month the major drivers of rising bond yields have come from outside the US. Economies in Asia, Europe and the dollar-bloc have all moved to price in rate hikes over the next 12 months having previously priced in rate cuts. In several places, we think this is "too much, too soon".
Our scenario probabilities are little changed as we end 2025 and look forward to the new year.
We increased the probability attached to a "soft landing", by far the likeliest outcome in our view. The chance of "hard landing" has been reduced, a reflection of tentative signs of stabilisation in some labour market indicators, such as small business hiring intentions.
Meanwhile, a combination of a benign near-term inflation outlook (relative to what’s priced into bonds), our expectations for a moderate softening of Q4 growth and the likelihood of a new "dovish" Fed Chair, means that we see a "no landing" scenario as the lowest probability outcome.
A rapid move to pricing in rate hikes among developed market central banks provides opportunities to add selectively to bond positions
This recent rise in bond yields is now offering attractive entry points for long bond positions in economies we have previously been wary of, such as the eurozone, as well as more tactically in Japan and Canada.
A disinflationary outlook for the UK heading into 2026 makes short-dated gilts attractive
The UK remains a favoured long position in shorter (five years and less) maturities, given signs of disinflation, a loosening of labour market conditions and following November’s Budget which pointed to marginal fiscal tightening in 2026.
Where does this leave us on US rates?
On the one hand, we believe growth will remain good going into 2026, helped by increased consumer fiscal support through the One Big Beautiful Bill. On the other hand, the labour market still shows vulnerabilities and this is half of the Fed’s policy mandate.
So in terms of outright directionality, we think better opportunities exist in other parts of the globe. Instead, the major opportunity in US rates remains in the yield curve where we continue to expect steepening. The underperformance of the 10 and 30-year bonds versus the two and five-year is a reflection of the US’ very weak fiscal dynamics (large budget deficits and rising debt-to-GDP) and the potential for the Fed to overstimulate the economy by easing too much because of a labour market soft patch.
At the time of writing, President Trump is yet to confirm his appointee as the new Fed chair, but any threats to the Fed’s independence would also support this steepening trade.
Why is the Fed buying bonds? Because their balance sheet got too small!
One notable development in the US in an otherwise quiet month has been the December Fed meeting, where they both cut policy rates as expected, but also announced they will be increasing the size of their balance sheet again with asset purchases – so called reserve management purchases.
This programme is not transformative, nor is it "quantitative easing" in the traditional sense: the Fed is buying bills up to a maximum of three-year maturity and the purpose is technical rather than monetary policy driven.
Nonetheless, this is a supportive action both for both short-dated US treasuries and the overall global liquidity outlook.
What about asset allocation?
We remain cautious on corporate credit given extremely tight spread valuations (spread reflects the premium paid to investors for accepting additional credit risk), but we marginally upgrade across the board reflecting a supportive macro environment. Were spreads to widen, we would increase our positivity and see this as a good opportunity to increase risk exposure here.
Meanwhile agency mortgage-backed securities and covered bonds remain our top picks in asset allocation.