Out-of-consensus calls on markets in 2025

Steven Abrahams | November 22, 2024

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Almost every market in US fixed income is trying to figure out the implications of the changing of the guard in Washington, DC. The new administration has promised change, and it looks like it is on the way. Most markets have already started to price the direction of change, but the magnitude is likely underpriced in a number of areas. Rate volatility should exceed expectations in some tenors but not all, credit and swap spreads should set records, yield curves should end up steeper than expected and MBS quality should surprisingly improve—all from the changing of the guard. Away from that, leveraged loans should top risk-adjusted returns and the market should still hold onto a mountain of cash. These are the things investors should look to for excess return in 2025.

Rate volatility exceeds expectations, especially in longer maturities

Besides the usual response to changes in inflation, growth and Fed policy, next year promises a fresh round of developments that should keep rate volatility high. The options market already expects volatility in short rates to rise for the next year but still sees volatility in longer rates declining. That sets up the market for a volatility surprise in longer rates next year, helping positively convex positions tied to longer rates and hurting negatively convex.

Options markets already see annualized volatility in 1-year rates rising from 93 bp in the next few months to nearly 120 bp a year from now (Exhibit 1). But volatility in 5- and 10-year rates looks set to decline, according to options prices. That seems implausible if the high correlation between short and long rates continues to hold. The correlation between 1- and 5-year rates in the last year has run around 0.82, and between 1- and 10-year rates around 0.70.

Exhibit 1: Markets expect rising vol in short rates, falling vol in longer rates

Source: Bloomberg, Santander US Capital Markets

The rising volatility priced into short rates almost certainly reflects a series of changes ahead, beginning with a possible challenge to Fed independence. The president-elect clearly prefers a Fed chair open to political input, which current Chair Powell looks determined to resist until his term as chair expires in May 2026. The president could try to fire Powell, but that would likely end up before the Supreme Court. Short of firing Powell, the president could appoint a rival when Adriana Kugler’s term as governor expires in January 2026. Auditions for that role could start next year. Depending on candidates, their willingness to accommodate the president and their chances of Senate confirmation, investors may want a new risk premium to compensate for a Fed more open to political considerations.

Besides a challenge to Fed independence, tariffs and deportations look likely to muddy the inflation and growth picture, and the Fed path along with it—all key influences on rate volatility. Tariffs should look like a one-time lift in the price of targeted goods and services, and deportations a lift in the cost of labor as long as they continue. It seems likely the Fed will look through the initial impact of tariffs and focus instead on the tendency for less trade to reduce growth. Similarly, the Fed could look through the impact of deportations on wages and focus instead on the reductions in spending and growth in the long run. Nevertheless, initial inflation pressures could keep the Fed from easing as quickly as markets might otherwise anticipate, making the Fed path less certain and keeping volatility high.

Credit and swap spreads set records

Extending or making permanent the 20 provisions of the Tax Cuts and Jobs Act of 2017 set to expire next year looks like a recipe for a material boost in Treasury supply and, consequently, another round of tightening in credit and swap spreads. TCJA extensions along with other tax incentives also should help corporate earnings. Returns in credit, for the same duration, should top Treasury debt.

The Congressional Budget Office has estimated that making the expiring provisions of the TCJA permanent would boost deficits by 17%, and the Brookings Institution has estimated that extension, along with some other minor changes to fiscal policy, would boost deficits by 22%. Expanded SALT deductions, lower taxes on overtime and tips and other incentives would add further to deficits. And a material boost to outstanding Treasury debt historically has reduced the yield gap between risk assets and the riskless curve, a finding highlighted by the World Bank, the Treasury Borrowing Advisory Committee and here at Santander. The track record of the TCJA generating enough growth to offset lower tax revenues is not encouraging. And cutting spending might offset some but not all of the deficits.

Since extending or making permanent all provisions of the TCJA would also increase corporate earnings, credit markets have already tightened in anticipation. Seeing legislation move the TCJA toward that point should tighten credit spreads further through the first half of 2025.

There are some risks to record spreads if rate volatility exceeds expectations and, as my colleague Dan Bruzzo points out, if deregulation of key industries leads to more mergers and acquisitions and leaves the affected balance sheets more highly leveraged. These risks look unlikely to offset the forces pushing spreads tighter.

Heavy Treasury supply also historically narrows the yield difference between swap and Treasury yields, with Treasury yields rising relative to swaps. Look for that to play out next year, too.

The yield curve steepens to beat expectations

The market already anticipates the yield curve will steepen next year, but the consensus is too light, setting up short duration to outperform long duration. With the current 2s10s slope at 4 bp, forward rates see it at 15 by in six months and 22 bp in 12 months. That slope instead looks much more likely a year from now to be at 50 bp or greater. The current shallow steepening of the curve likely reflects expectations that the Fed will hold off on any cuts as tariffs and deportations play out. The risk to that expectation is that the Fed looks through the short-run impact of these policies on prices and slowly continues to ease. My colleague Stephen Stanley also expects the Fed to ease more than implied by fed funds futures, almost certainly bringing 2-year rates below implied forwards. It is also likely that longer rates rise as extension of the TCJA moves through Congress. Shorter rates should end up lower than current implied forward rates, and longer rates should end up higher, all else equal. The 2s10s curve consequently ends up much steeper than implied. That should help outright steepening trades, conditional steepening trades—especially with volatility likely to exceed expectations, shorter interest rate floors and shorter inverse IO MBS.

The quality of MBS improves with efforts to reign in Fannie Mae, Freddie Mac

The last Trump administration steadily looked for ways to reduce the footprint of Fannie Mae and Freddie Mac in mortgage originations, and efforts by the next one to do the same should help certain existing pools outperform TBA.

The last administration took an occasionally blunt approach to reigning in the enterprises, the Trump-appointed regulator resorting in 2021 to putting caps on originator securitization of investor loans in agency pools. The Biden administration ended that effort. Some investors have already started speculating that the new administration will try to raise equity for the two agencies and privatize them, but the obstacles to that—especially the likely flight of many foreign investors and regulated banks, the resulting wider MBS spreads and higher mortgage rates, and political opposition from homeowners, originators, realtors and others—make the chances of that vanishingly close to zero. Instead, it is much more likely the new administration could play with the grid of loan-level price adjustments and other delivery charges.

Raising the LLPAs and other charges could steadily tilt the economics of securitization toward private rather than government MBS, something my colleagues Chris Helwig and Brian Landy highlight in their calls for MBS next year. But one result of tilting the economics for new loans is that old loans, the ones backing existing MBS, could suddenly find it more expensive to refinance. Existing MBS would become more convex, and more valuable relative to new loans. Investor loans, jumbo conforming loans and loans to borrowers with low credit scores could be the main beneficiaries. MBS investors could add exposure in these types of specified pools as a call on new efforts to reign in the GSEs.

Leveraged loans and CLOs win the race for risk-adjusted return

Over most of the last five years, except for the onset of pandemic in the first quarter of 2020, leveraged loans and CLOs have posted some of the best returns for the risk or volatility taken, and circumstance should favor that result again next year (Exhibit 2). That should hold despite rising loan and CLO supply.

Exhibit 2: Leveraged loans and CLOs have often posted top risk-adjusted returns

Note: Data shows annualized daily returns and volatility of returns based on the Morningstar/LSTA leveraged loan index, the Palmer Square CLO indices and the Bloomberg indices for all other assets.
Source: Bloomberg, Santander US Capital Markets.

The good returns in loans and CLOs broadly reflect both the low duration of these floating-rate assets and their relatively high margins over the floating index. The low duration avoids interest rate volatility, and the high margin creates significant compounding. When LIBOR and then SOFR ran near zero, the margin created the return. And as SOFR then rose to a peak around 5.30%, both the index and margin created the return.

With the Fed likely to ease and the yield curve likely to steepen next year, loans and CLOs will probably lose some of their advantage over other sectors in returns from coupons. The big difference should come in return volatility. Loans and CLOs as usual should accrue return steadily through the year while rate volatility keeps the measured risk of returns in assets with longer duration relatively high. Other assets could top loans and CLOs on absolute return, but probably not after adjusting for risk.

The performance in loans and CLOs should play out even as the loan market starts to grow again. Rising SOFR rates and a cooling market for M&A has left the outstanding balance of leveraged loans swimming sideways for the last few years just below $1.4 trillion, but that looks likely to change next year. The Fed path should drag SOFR lower, tariffs and deportation should change the supply chains and economics of technology, leisure and hospitality, homebuilding and other industries and looser regulation at the FTC and FCC should allow more M&A. All of this should encourage growth in leveraged lending. And with spreads in other parts of the credit markets likely to be tight, the rates available to borrowers should be very competitive. Outstanding par should top $1.4 trillion next year.

The market holds onto a mountain of cash

Heavy balances in money market funds should be good for repo market liquidity next year and eventually good for risk assets, even though the extraordinary growth of money market AUM should come to an end. AUM recently touched a record $6.67 trillion, growing rapidly over the last few years as Fed tightening pushed money market yields well above all other yields along the Treasury curve and well above bank deposit rates (Exhibit 3).  Money funds historically compete with other riskless assets and with bank deposit rates, with fund AUM rising as a share of GDP when money market yields top their competitors’. For money funds to actually shrink, either the yields on money market instruments need to drop below the yields on longer parts of the yield curve or those money market yields need to drop below the yields on bank deposits.

Exhibit 3: Money market funds have collected record amounts of cash

Source: Bloomberg, Santander US Capital Markets

With the Fed most likely to keep easing next year and with Treasury supply tending to push longer yields up, the yield advantage in money market funds should narrow and then disappear. At that point, AUM should begin to trend down. But the likely slow pace of Fed easing should make that process similarly slow, so repo is not about to lose an important source of funds and risk assets are not about to see a rush out of cash. As the year goes on however, the trend out of cash should pick up momentum.

Positioning

If all of these market surprises play out, then investors can expect excess return from a number of different portfolio positions:

• Leaning toward more convexity rather than less
• Adding to credit and other risk exposures over Treasury debt
• Favoring shorter duration over longer
• Holding specified MBS rather than TBA
• Holding some exposure to loans, CLOs or other floating-rate debt

Expecting healthy conditions in financing markets