Yield outlook: The pendulum has swung too far

As we enter 2025, rate markets across Western economies remain in a challenging situation. Long-end rates have surged significantly since the beginning of December, with the US leading this global movement. Additionally, country-specific challenges are present, such as in the UK, where concerns about a potential new 'Liz Truss moment' have made investors cautious. Recently, the strong US jobs report for December has again tempered expectations for easing by the Fed. Currently, the market is pricing in only a single rate cut of 0.25 percentage points from the current level of 4.25-4.50% by the end of 2026. This would leave the endpoint, also known as the terminal rate, more than 1 percentage point higher than the Fed’s own forecast from December. The terminal rate will remain a significant uncertainty factor for the rate markets for most of 2025, but we still assess that it is closer to 3% than 4%. This suggests substantial declines in USD (and EUR) rates ahead, although the timing remains very uncertain.

Rising term premia reflect concerns about debt

Since early December, the rising doubt on Fed easing in 2025-26 has been coupled with marketspecific dynamics, particularly affecting the long end of the yield curve. According to our preferred models, the so-called term premium in the bond market – the value of holding a longterm versus a short-term government bond – has increased by 0.6 percentage points on a 10Y US Treasury bond since the beginning of December (see the chart on page 2). This is a significant rise, building on the generally upward trend observed since Trump and the Republicans gained momentum in the polls in early October. In our view, the sharp increase in the term premium is related to renewed focus on the US debt outlook and, to some extent, the rest of the West.

But why did the rapid rise in the term premium occur in December, rather than as an immediate reaction to the election results in November?

It is difficult to provide a definitive answer, but one possibility is that a combination of 1) a more hawkish Federal Reserve and 2) stronger growth and inflation figures during November and December has now begun to more directly affect the appetite for duration. This is backed by recent US government debt auctions, which indicate that investors are demanding higher rates to absorb the offered duration. In any case, it is hard to argue that Trump and the Republicans' fiscal plans were decisive for December's rate increase. If anything, the difficult budget negotiations during the month showed that the party's slim majority in the House of Representatives and questionable party discipline could make it more challenging for Trump to pass a significant fiscal package. This should, in isolation, point to lower rates.

The recent months' combination of 1) a stronger dollar, 2) higher (real) interest rates, and 3) declining stock prices has contributed to a noticeable tightening of financial conditions in the US. So far, however, there is little indication that the Fed intends to intervene and counter this movement. In the central bank's view, inflationary risks are increasing, and the prospects of higher tariffs on trading partners, easier fiscal policy, and declining growth in the labour force due to reduced immigration are all factors that could further fuel price pressures in the economy. In this environment, it is natural for the Fed to remain cautious – as long as the tightening 

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