By John Sidawi and Ihab Salib, Senior Portfolio Managers at Federated Hermes
Ballooning public debt is forcing many countries to overhaul fiscal rules, which could have a significant impact on credit markets in the months ahead.
The last couple of years has seen global monetary policy effectively spearhead valuations in both equity and fixed income markets. In 2025, however, we expect fiscal initiatives to rise to the top of investors’ concerns.
Ballooning public debt is forcing many countries to reboot fiscal policy to try and ensure public finances remain on a sustainable path, according to the International Monetary Fund (IMF).1
As a result, global monetary policy is poised to become more of a ‘reaction function’ than a leading indicator, and this shift could have sizable implications for credit markets, particularly at the short end of the yield curve, as rising sovereign borrowing costs impact longer-duration assets.
The fall and subsequent stabilisation of inflation over the last year has given green light to leading central banks to begin their easing cycles. In the second half of 2024, the US Federal Reserve slashed rates three times – including a 50bps cut in September – and the Bank of England cut twice. The European Central Bank (ECB) cut rates four times over the period.
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However, many of the world’s largest economies – including the UK, China, Germany and the US – are in the midst of various stages of fiscal expansion. In the Autumn, the UK government overhauled its fiscal rules to ramp up public spending by £70bn a year2 and China launched a fiscal stimulus package to boost growth.
Germany, meanwhile, looks poised to relax its so-called ‘debt brake’, which limits borrowing; and the incoming US administration under President Donald Trump is set to implement sweeping tax cuts, which could increase the deficit.
This shake up of government borrowing and spending is likely to have a significant knock-on effect on various asset classes in the months ahead and increases the probability that ‘fiscal expansion’ will develop into a key macro theme in 2025.
Impact on short duration
Looser monetary policy across developed economies over the past year has been positive for many companies. Interest rate cuts have made it easier for corporates to refinance their debt, strengthening balance sheets and boosting credit quality.
Falling interest rates typically apply downwards pressure to the front end of the yield curve, encouraging investors to move out of cash and liquidity products and seek out more attractive returns by extending duration.
In 2024, short-duration credit benefited from this shift and saw positive inflows –following net outflows in previous years3 – and combined with the shift in fiscal policy presents investors with a compelling opportunity to lock in elevated yields at the front end of the curve at the present time.
One highly plausible scenario, for example, is that fiscal expansion in some countries leads to a resurgence in inflation, forcing central banks to slow the pace of monetary easing. Should this happen, investors would have an opportunity to secure short-term rates elevated beyond what’s currently priced in, with less exposure to interest rate volatility.
Risks on the horizon
As we head into 2025, geopolitical risk remains a pressing concern. On top of ongoing military conflicts in Ukraine and the Middle East, the rise in trade protectionism, frayed international relations, and widespread political upheaval have heightened market uncertainty, adding to the appeal of short-term credit.
Short duration strategies provide investors with the ability to move up the yield curve from liquidity products and cash, accessing potentially higher returns, while sidestepping some of the exposure to uncertainly and risk that can be inherent in longer-duration credit.
1 World Economic Outlook, October 2024: Policy Pivot, Rising Threats
2 UK Autumn Budget Signals Fiscal Expansion
3 Source: Morning Star, Federated Hermes
