Webinar recap: An institutional investor guide to the 2025 interest rate environment
Executive summary:
- 2024 was a tough year for fixed income, with bond yields rising due to inflation normalization and fiscal policy concerns. We expect the Fed to gradually cut rates in 2025. Meanwhile, we believe global bond markets are presenting new opportunities, particularly in the UK.
- Investors are increasing hedge ratios and duration exposure as rates normalize. The U.S. dollar remains strong but could weaken, while the Japanese yen appears undervalued. Credit spreads are tight, leading investors to explore securitized assets and credit derivatives for potentially better returns.
- Bonds remain a key diversifier, despite their recent challenges. Trend-following strategies can also be utilized as an alternative diversifier to bonds.
On Jan. 28, Russell Investments hosted a webinar on the outlook for interest rates, foreign exchange (FX), and credit markets in 2025. The discussion featured insights from three Russell Investments experts: Paul Eitelman, chief investment strategist for North America; Van Luu, director and global head of solutions strategy for fixed income and foreign exchange markets; and Thomas Boyd, portfolio manager for customized portfolio solutions.
Below is a summary of their conversation.
2024: A rough year for fixed income
Luu began by noting that 2024 was a year of inflation normalization following the shock caused by the COVID-19 pandemic. The resilience of the U.S. economy last year allowed the U.S. Federal Reserve (Fed) to begin a rate-cutting cycle in September, he said. Despite this, U.S. Treasuries remained in a bear market during the year, with long-term yields rising significantly due to election outcomes and fiscal policy concerns, Luu said. On the positive side, he noted that credit benefited from robust growth, with credit spreads tightening to new cycle lows.
“Overall, 2024 was a painful year for bonds, especially U.S. Treasuries, as markets adjusted to the end of low interest rates and the onset of quantitative easing. Looking forward, I think much of what happens this year depends on what the Fed does,” he stated.
Fed policy and the bond market outlook
Next, Eitelman provided insights into the Fed’s potential future path for rates. Although some market participants are speculating that the U.S. central bank could halt rate cuts or even revert back to rate hikes at some point this year, he stressed that he still expects the Fed to gradually cut through 2025. “I think the Fed will lower rates two to three times this year, and I anticipate a new normal target rate of around 3.25% over the next one to two years,” he stated.
Eitelman noted that even though the U.S. economy remains strong, inflation is gradually declining. “Continued cooling in the labor market and stable inflation expectations suggest a path for inflation to return to 2%,” he said. However, Eitelman stressed that uncertainty remains regarding fiscal policies under the new administration of U.S. President Donald Trump, which could lead to potential market volatility.
From a strategic positioning perspective, he explained that Russell Investments has been adjusting portfolios based on market overshoots. Last August and September, when bond yields were falling due to recession fears, the firm reduced duration risk, Eitelman said. More recently, with rates rising, he said that bonds are again looking attractive. “This could particularly be the case if the U.S. 10-year Treasury yield moves to around 4.8%-4.9%,” Eitelman remarked.
Global sovereign bond markets
Luu noted that global bonds are becoming more attractive following the recent selloff. In the UK, he said that gilt yields have reached a 27-year high, making them particularly compelling given the country’s weaker economy. Conversely, he said that Japanese bonds appear less attractive due to the Bank of Japan’s unique monetary policy stance of raising rates while other central banks are cutting.
Institutional strategies in fixed income hedging
Next, Boyd discussed how institutional investors are positioning themselves in rates markets. Clients are increasingly considering whether to introduce fixed income beta into liquidity pools, he said. Previously, cash reserves earned attractive money-market yields with an inverted yield curve, making longer-duration investments less appealing, Boyd explained. However, with rates normalizing, there is renewed interest in duration exposure, he said.
“Today, some institutional investors are actively extending duration or increasing their hedge ratios to lock in attractive yields. Pensions with improved funding status due to rising rates are also exploring de-risking strategies by increasing their duration exposure,” Boyd stated.
Foreign exchange market trends
Pivoting to currencies, Luu noted the U.S. dollar’s recent strength, which he said has been largely been driven by U.S. economic exceptionalism, technology leadership, and the potential for tariffs. However, with positioning becoming stretched and valuations extended, a reversal in dollar strength is possible, Luu stated.
One standout opportunity Luu sees in FX markets is the Japanese yen, which he said appears significantly undervalued. “Japan is undergoing a different monetary cycle, raising rates while other central banks are cutting. If the right catalyst emerges, we think the yen could experience substantial appreciation,” he remarked.
Institutional FX hedging strategies
Focusing in on FX hedging strategies, Boyd explained that institutions with non-dollar assets are evaluating their hedging strategies, particularly in light of the U.S. dollar’s strength. “We’ve seen many investors consider increasing their hedge ratios on foreign-denominated assets as a risk-off hedge in case of a global economic slowdown,” he said.
Credit market overview
The conversation shifted to credit spreads, with Luu and Eitelman noting how spreads today are at historically tight levels, reflecting strong corporate balance sheets and earnings growth. In short, this means that investors are not being adequately compensated for taking on credit risk in their portfolios, Eitelman said.
Amid this backdrop, Russell Investments is looking at the securitized market, including agency mortgage-backed securities, asset-backed securities, and collateralized loan obligations (CLOs), which can offer better value and more attractive spreads than traditional investment-grade and high-yield corporate bonds, he explained.
Institutional credit positioning
Boyd noted that some clients with significant credit exposure are considering hedging strategies using index credit derivatives. This allows them to manage credit beta without disrupting allocations to active managers, he remarked.
Conversely, Boyd said that clients with lower credit allocations are exploring whether to increase exposure, particularly in investment-grade credit, which still offers decent yield potential even if spreads widen slightly. Institutions are using overlays to tactically adjust their credit exposure rather than making wholesale changes to underlying manager allocations, he noted.
The diversification role of bonds
Eitelman, Luu, and Boyd wrapped up the webinar by answering questions from the audience. A key question addressed was whether the team still sees bonds as a diversifier to risk assets. Luu stressed that while bonds failed to provide strong diversification in 2022 due to a supply-driven inflation shock, they remain a valuable hedge in many scenarios. He said that in times when bonds underperform, trend-following strategies can be an additional diversification tool. “Ultimately, I’d say don’t give up on bonds—but also consider other diversifiers,” he said.
U.S. fiscal trajectory and long-term risks
Another question from viewers dealt with concerns over the growing U.S. fiscal deficit. Eitelman noted that today’s deficit-to-GDP ratio is high at around 6%--and expected to rise further. He said that while long-term challenges exist, the near-term risk of a fiscal crisis appears low due to sustained economic growth and the demand for safe assets from pension funds. However, Eitelman stressed that long-term entitlement spending issues will need to be addressed within the next decade.
Liability immunization for pension plans
The webinar concluded with a final question about how pension plans can protect themselves from fluctuating interest rates. Boyd said that in the context of liability-driven investing, increasing hedge ratios aligns with immunization strategies for pension plans. “Given current market conditions, moving toward higher interest-rate hedge ratios makes sense as part of a de-risking approach,” he stated.