Why We’re Optimistic About Government Bonds Heading into the New Year

Why We’re Optimistic About Government Bonds Heading into the New Year

On balance, our view is that the interest rate environment in the U.S. and Canada may continue to offer an attractive risk/return profile for investors in government bonds.

The financial markets’ reaction to Donald Trump’s U.S. presidential election victory on November 5 went pretty much according to script: risk assets such as equities and cryptocurrency responded positively to his anticipated pro-business policies, and U.S. bonds sold off, at least initially. On the surface, that looked like a replay of 2016 after Trump won the first time around, and it fed into the apparently accepted wisdom that the incoming administration’s policies will mean “more of the same” for investors – robust stock markets, but a lot of upward pressure on interest rates (rates).

That assumption might not play out quite as expected, at least regarding rates. Indeed, our base case is that possible shifts in U.S. rates may be moderate next year, albeit with downside risk likely outweighing upside potential in the process. As for Canada, despite the supposedly inflationary impact of Trump’s policies on the global economy, we do not see the Bank of Canada diverting from its current easing course. Yes, there are risks to this outlook, but on balance our view is that the rate environment – in the U.S. and Canada, in particular – may continue to offer an attractive risk/return profile for investors in government bonds.

There are several reasons why the U.S. rate environment under Trump could be different this time around. First, unlike in 2016, the U.S. Federal Reserve (Fed) is now in a cutting cycle rather than a hiking cycle. Eight years ago, the Fed was trying to gradually normalize monetary policy after years of near-zero rates in response to the 2008 global financial crisis. Since September 2024, however, the Fed has been easing and we expect the U.S. central bank to maintain its current policy path until there is more clarity regarding Trump’s potential policies and they are enacted by the new administration.

Second, unlike in 2016, Trump’s victory in 2024 was not a complete surprise, meaning that the market had already largely priced in the likelihood of his win. For instance, yields on the 10-year U.S. government bond had already risen nearly 70 basis points ahead of this election, whereas they increased by just over 80 basis points following Donald Trump’s 2016 victory.

Finally, the new administration’s assumed lack of fiscal discipline may not turn out to be as severe as anticipated. It’s uncertain that the Trump Republicans’ policies will result in larger deficits than those of Democrats, who have run deficits higher than 5% of GDP since the beginning of 2023 even with the economy near full employment. Furthermore, the market has focused primarily on Trump’s tax cut plans, but it has largely overlooked potential spending cuts. While a Republican sweep is generally perceived as likely to increase the deficit, we believe that a Republican Party (GOP)-controlled Congress would make it easier for the administration to implement cost-cutting measures alongside tax cuts.

For those reasons, we do not anticipate rates to rise as sharply as they did in 2016 and 2017 after Trump’s first election. Generally, the 10-year U.S. government bond yield appears fairly valued for 2025. Fed projections suggest its rate will drop to 3.375% by the end of 2025 and to 2.875% by the end of 2026, contrasting sharply with the U.S. market’s expected terminal rate of closer to 3.75%. Assuming the market’s rate pricing turns out to be the better estimate, along with a positive 50-basis-point term premium (reflecting an upward-sloping curve by the end of the easing cycle), the 10-year yield would end the cycle around 4.25% – roughly aligned with current levels. But given the Fed’s own expectation of more aggressive cuts than the market projects, we see additional downside risk to this forecast for 2025.

Government Bond Yields Near Their 20 Year Highs

Source: Bloomberg LP as of November 27, 2024

The primary risks to our outlook stem from potential tariffs and immigration policies. Should Trump impose duties on all foreign goods (including tariffs of 25% on Canada and Mexico and 60% or more on Chinese imports), we believe it could drive renewed U.S. inflationary pressure. Similarly, large-scale deportations could tighten the labour supply, likely driving up wages and, consequently, inflation. In either scenario, elevated inflation could prompt the Fed to reduce rates less than anticipated, resulting in an upward shift across the yield curve.

But what about Canada? Clearly, its economic landscape contrasts sharply with that of the U.S. Real GDP growth in Canada has remained below 2% since early 2023, while the U.S. growth rate was closer to 2.5%. Additionally, Canada’s year-over-year inflation was 1.6% in September (or 1% excluding mortgage interest costs), whereas U.S. inflation remains above the Fed’s 2% target. At 6.5%, Canada’s unemployment rate is now well above the non-accelerating rate of inflation, or NAIRU – the minimum level of unemployment to spark inflation; in the U.S., unemployment is running at a much lower 4.1%. As a result, we anticipate the Bank of Canada will proceed with aggressive rate cuts in 2025, further driving down government yields.

Given our relatively optimistic outlook on rate trends, we remain positive on fixed income headed into 2025. Government bond yields across the curve, in both Canada and the U.S., are at levels near their highest in the past 20 years. We believe this environment may allow fixed income markets to generate substantial income for investors, meaning that any potential capital losses could be at least partially mitigated by income generation – a potential balanced risk-return profile.

Second, and importantly, we see fixed income as an effective hedge for equity exposure. After significant negative returns in both global equities and bonds in 2022, some questioned the relevance of the 60/40 portfolio. However, with inflation now below 3% in most developed markets, including the U.S. and Canada, we believe the inverse correlation between bonds and equities could return.