Fidelity releases its fixed income outlook for 2025. In 2025, the focus of the fixed income market will be on the level of US interest rates at the end of the current rate cycle. Unlike market expectations, Federal Reserve policy officials have a more mild outlook for rates in the next two years. The market is currently estimating that the final rate will fall to around 3.5%, but the implementation of new tariff measures is likely to push up inflation, coupled with the expected expansion of the US fiscal deficit next year, these factors may lead to a final rate higher than the current market expectation level. Areas of interest in 2025 Defensive US investment grade bonds: to hedge against economic recession risks Global short duration bonds: to lock in a substantial overall yield Asian high yield bonds: to capture attractive spreads and take advantage of spread tightening opportunities It has been proven that investors' estimates of the bottom level of the final rate often change. For example, when the Fed cut rates by 50 basis points to 5% in September, many investors who originally expected only a 25 basis point cut were surprised, leading to a higher evaluation of the final rate in the market, because investors believed that the Fed took early measures to address the risk of economic growth, thus no need for too much rate cuts overall. Therefore, as shown in the chart below, contrary to market expectations, Federal Reserve policy officials have a more moderate outlook for rates in the next two years. However, there are other factors brewing. US recession risks seem to be underestimated When looking for opportunities in the fixed income sector, investors need to be aware that the market often has difficulty determining the impact of geopolitical risks and other factors, which could potentially undermine economic growth. The recent rate hikes have had an unusually mild impact on credit issuers. Many companies have taken advantage of the opportunity to lock in low rates amidst multi-year lows, locking in low rates for debt, and depositing cash into short-term deposits or money market funds to earn higher interest, resulting in a decrease in net interest costs. Although some issuers have run into trouble, 54% of default cases as of the end of September this year have been resolved through debt exchanges, reducing losses for investors. However, even with low rates locked in, issuers will eventually need to refinance, a problem that investors and policy officials will gradually pay more attention to in 2025. In the recent US elections, exit polls showed that 68% of voters believe the US economy is "not very good or very bad." Regardless of how economic data may look, American people are clearly dissatisfied with their financial situation. If the US economy deteriorates over the next 12 months, the Fed may be forced to cut rates more aggressively than expected, leading to even lower final rates. Considering current credit spreads are narrow, investors may consider increasing their holdings in US bonds, especially higher quality bonds. China: Waiting for further policy One major focus next year is when and how large-scale stimulus measures will be implemented in China. These measures will not only boost economic growth in China and the entire Asian region, but may also export inflationary pressures abroad. As China prepares for its next move and considers how to respond to US tariff measures (if implemented), Fidelity is assessing the situation that credit investors will face in 2025, such as: The Chinese real estate industry currently accounts for about 5% in the JP Morgan Asia Credit Non-Investment Grade index, lower than its peak of over 30%. The index has become more stable and balanced. Currently, the average rating of Asian high yield bonds is BB, and ratings may continue to be upgraded, especially in Asian frontier economies and the BB category, where bonds with potential upgrades have appeared. The average credit spread of Asian high yield bonds exceeds 500 basis points, higher than the 20-year average, at an attractive level, indicating that there is room for spread tightening. In addition, the average duration is only two years, so the sensitivity to interest rate changes is lower. These factors create a positive environment for Asian high yield bonds, especially if the Fed continues to ease policy and China introduces more monetary easing and stimulus measures. The environment for Asian investment grade bonds is also favorable. Due to issuers being reluctant to borrow dollars at higher rates (higher than local markets), the supply of Asian USD investment grade bonds has significantly reduced, while investor demand remains high. With the expectation of a strong US dollar in 2025, this trend is unlikely to reverse. Monetary policy outlook Over the next 12 months, fiscal spending in the US and China is expected to increase significantly. The market may be optimistic about this prospect, but it also reflects that future growth is not really healthy, coupled with escalating geopolitical tensions, casting a shadow over economic prospects. To mitigate these concerns, Fidelity expects the Fed to take action actively and bring rates down to a neutral level. This can be seen from the Fed's significant rate cuts in September, followed by a 25 basis point cut in November. However, if inflation picks up, the space for rate cuts may be limited. The US may very well fall into stagflation, in which case the Fed may prioritize economic growth. The European Central Bank is also concerned about high wage and service sector inflation, but structural declines in the euro area (especially in Germany) give investors reason to increase their durations. If the Fed further cuts rates, central banks in countries like China, South Korea, and Indonesia will be able to comfortably continue lowering rates, providing support for Asian bonds. On the other hand, if the Fed's stance is less accommodative, the Bank of Japan, after raising rates for the first time in 17 years in March 2024, will have more room for policy normalization. In reality, each central bank must act at its own pace. In 2025, one of the challenges fixed income investors face is to keep track of every step of each central bank.