.png)
What happened last week?
December's Federal Reserve meeting delivered a plot twist that caught markets off guard. While the anticipated 25bp rate cut materialized, Powell's hawkish messaging and revised projections sent shockwaves through financial markets. Describing the decision as "a closer call," Powell revealed internal committee divisions, with one member dissenting and others expressing reservations. The Fed's updated economic outlook painted a more challenging inflationary picture, with PCE inflation now expected to remain above target until 2027 and 2025 inflation revised up to 2.5%. Despite these concerns, growth prospects improved, with 2025 GDP forecasts climbing to +2.1% and unemployment projections trimmed to 4.3%. The Dot Plot revealed a dramatic shift in the Fed's rate trajectory, halving expected 2025 cuts from four to just two 25bp moves. Adding to the hawkish tone, the neutral long-term rate estimate jumped to 3%, signaling a structural shift in monetary policy framework. This adjustment suggests the Fed anticipates a "higher for longer" scenario extending beyond current market expectations. Meanwhile, the Bank of England maintained rates but showed surprising dovish undertones, with three MPC members advocating for immediate cuts. This split vote prompted markets to pare back 2025 rate cut expectations from 90bp to 60bp, with February cut probability slipping to 70%. In Asia, the Bank of Japan maintained its cautious stance despite inflation surprises, leaving rates unchanged but laying groundwork for potential 2025 action. Markets are pricing 43bp of hikes and a 42% probability of a January move, reflecting growing expectations of policy normalization. The BoJ's patience stems from concerns over external uncertainties, including U.S. tariffs and Chinese economic developments, as well as FX market volatility. This global monetary policy divergence sets up an intriguing backdrop for 2025, with central banks navigating different stages of their policy cycles while facing common challenges of persistent inflation and uncertain growth dynamics.
The U.S. bond market weathered a perfect storm as Powell's hawkish pivot sent shockwaves through yields. The 10-year Treasury breached 4.50% - its highest since May - while 30-year yields approached the psychological 4.70% barrier, dramatically steepening the yield curve. The iShares USD Treasuries ETF reflected this turbulence, dropping -0.7% and barely holding onto its 2024 gains of +0.7%. The yield curve transformation has been remarkable, with both 2s10s and 3m10s spreads swinging to +22bps, marking a significant shift from their inverted positions earlier this year. TIPS emerged as a bright spot, delivering +1.7% YTD returns as inflation expectations evolved, with 10-year breakevens climbing to 2.30% and real yields surging to 2.24% from 1.7% at the start of 2024. The short end remained relatively anchored at 4.31%, reflecting the Fed's cumulative 100bp of easing in 2024. Looking ahead to 2025, current valuations appear more attractive than a year ago, potentially providing a buffer against market volatility. European bonds demonstrated greater resilience, with the iShares Core EUR Govt Bond ETF limiting losses to -0.3% while maintaining an impressive +1.9% YTD gain. The 10-year Bund yield's modest 7bp rise to 2.29% was cushioned by Germany's strategic decision to slash 2025 debt issuance by 13%. French bonds saw slight widening, maintaining an 80bp spread over Bunds, while Italian spreads increased marginally to 116bp. The inflation-linked segment struggled, with the iShares EUR Inflation-Linked Govt Bond ETF dropping -0.8%, ending flat for 2024. German breakeven inflation remains subdued at 1.76%, well below the ECB's target, setting up an interesting dynamic for European fixed income markets in 2025.
Emerging market
The emerging market landscape presented a tale of contrasts, as the Bloomberg EM Hard Currency Index retreated -1% amid rising U.S. rates. Sovereign spreads widened 3bps to 251bps while corporate spreads increased 7bps to 209bps. However, the headline weakness masks a transformative year for EM high-yield, which saw spreads compress below 400bps for the first time since 2018, driven by remarkable recoveries in Argentina, Pakistan, and Egypt. Brazil's markets endured a rollercoaster week as 5-year CDS spreads spiked to 220bps before moderating to 200bps. This volatility stemmed from strained government-market relations and fiscal policy uncertainty, exacerbated by a controversial income tax exemption package. The central bank's hawkish stance, pushing the SELIC rate to 12.25%, coupled with President Lula's calls for lower rates, added to market instability. Romania faced its own challenges with 5-year CDS reaching 180bps, though the new pro-European coalition under Prime Minister Marcel Ciolacu offered hope. The coalition aims to address the EU's largest budget deficit (over 8.5% of GDP) and counter growing far-right influence ahead of early 2025 presidential elections. Mexico's central bank maintained its methodical approach, delivering a 25bp cut to 10.25%, preserving an attractive 550bp differential with U.S. rates. Mixed signals on inflation risks and monetary conditions have complicated market expectations, though the rate differential remains supportive compared to the 475bp historical average. Despite near-term challenges, strong fundamental improvements in key markets and attractive valuations suggest selective opportunities heading into 2025.
