2025 Bond Market Outlook

Guest post by: John Hallacy, John Hallacy Consulting

Review of 2024 and a glimpse in what to expect in 2025

There have been peaks and valleys in yields and performance during the current year. Flows to the funds have been positive for most of the year. The Fed has largely determined the path for rates and the markets.

Calendar year 2024 has largely been a story of heightened supply and a Fed that is walking the line between inflation and keeping the labor market relatively strong.
On the supply aspect, municipal volume is closing in on the target of $500 billion for the year that will stand as an all-time high. Flows to the funds have been fairly steady through the year and now stand at approximately $42 billion.

Volume in the primary in 2015 was $397.7 billion. Current refunding activity will be robust during 2025 especially if rates continue to fall. This contribution to volume from refunding activity among other factors is expected to propel volume to more than $500 billion in 2025. One pundit has pegged volume for the new year to over $700 billion.
We think the chances of obtaining such a level are relatively low. If this threshold is attained, the market would be positioned to cheapen and it is probable that spreads would widen appreciably. This scenario is based on long term empirical observations. However, we do acknowledge that 2025 is likely to be a year of many changes in policies and in markets.
Corporates should remain on trend as rates ease and the curve returns to pre-pandemic characteristics. A lighter regulatory approach should also ease the path to more activity.

The Fed future path and the outlook for rates

The Fed has maintained a dovish stance for most of 2024. With the conclusion of the last meeting of the year, the Fed has now eased by one hundred basis points. However, along with the twenty-five basis points cut in December, the dot plot was altered to signal less easing in the year ahead. This move radically changed the tone in the markets. Equities traded off sharply and the ten-year Treasury has now moved up to 4.56% as of this writing. This level represents a recent high in yield. We anticipate a strong dose of volatility in the new year.

Throughout 2024, the Fed has been primarily focused on inflation and driving the level down to the 2% target. Inflation now stands at 2.7% and is down sharply from the 9% level of last year. Chair Powell has made it quite clear that the Fed is still committed to steering a course to attain the 2% target level.

The Fed began to shift its focus from inflation to the health of the labor market in the last couple of months. The unemployment rate at 4.2% is up from the 3% handle but still is not overly worrisome. A sharp eye is on the level of GDP but the most recent level of 3.1% has not declined or slowed all that much. The Fed’s view is that the economy has maintained remarkable strength but there are some signs of slowing.

The crystal ball for next year is much more tentative than at present. Many observers are anticipating pauses in the easing trend for the next couple of meetings beyond December. The basic premise is that inflation while coming down has been resistant to going lower of late. There is real concern that the introduction of higher tariffs will drive inflation higher than desired. Drawing on the experience of the last round of tariffs in the first Trump term, there was not a pronounced effect on the economy or on prices generally. This time has the possibility of turning out differently because the level of tariffs under discussion is higher and will apply to more categories of goods.

Chair Powell is likely to finish out his term that ends in 2026 as far as we can determine today. He has been a steady hand through the pandemic and beyond and would be expected to exercise great judgment and caution over the next year. Inflation is relatively tame for now. But we will experience whether tariffs and newly instituted policies will lead to upward pressure for inflation once again. Such a scenario would require other actions by the Fed. As the mantra goes, the Fed will be expected to act according to the fresh incoming data over time.

Rate outlook

The interest rate curve has been normalizing in recent months with short rates finally falling below long rates. However, the curve from the short end to the long end is not especially steep at this point. We would anticipate more steepening during 2025.

Rates have been descending along with the Fed rate cutting that commenced in earnest in September of 2024. However, the short end has been slower to decline in yield. The curve had been inverted for the greater part of the year. Some of the levels that we see in municipals and corporates remains dependent on the forces of supply and demand for the paper.

Corporate activity

Issuance had been on pace for a sound year. We have not seen as many headline highlights as in years passed. The expectation is that the M&A pipeline is being built for a more active 2025. As rates descend, we would expect that some of the M&A activity would be more likely to be fulfilled with some borrowing.

Spreads in the corporate market have been favorable for issuers for the bulk of 2024. High grade borrowers have been coming to market in the +100 basis points over the equivalent Treasury maturity. High yield paper has been coming to market in the +200 basis points over the equivalent Treasury range. High yield has been robust in part due to the low level of bankruptcy filings in this stable economy. The latter is considered a relatively tight spread. High yield has been robust in part due to the low level of bankruptcy filings in this stable economy. There is every reason to believe that there will be some spread widening as the pace of activity and issuance accelerates in 2025. High yield has been robust in part due to the low level of bankruptcy filings in this stable economy.

Bonds for general corporate purposes dominated the calendar. The Albertson’s and Kroger merger has been a signal of how challenging it remains to get deals done. The general focus is on reducing operating costs and becoming more efficient. More activity will contribute to more issuance on some level. Most pundits agree that incoming regulators will be more receptive to the completion of M&A activity.

Economic performance remains solid

The readings on employment and unemployment as well as on earnings indicate continued strength in the economy. There is no recession on the horizon. Although there has been some slowing in hiring, people are holding onto their positions. Large scale layoffs have been few. The anticipated rightsizing of the federal government may provide the first real change in the current status of the economic picture.

Given that the economy is performing well, there is a considerable focus on just how strong economic activity will be during this holiday season. The increase for this year is in the mid-single digits that is closer to the perennial average. There is a lot of fretting over the exercise of caution this year. There is some speculation that big ticket items will be less sought after. We know that this time accounts for a substantial percentage of annual retail spending. Simply put, we believe that the concerns are ahead of the reality. In the end, the holiday spending for this year should be in the range. Some purchases including big ticket items will probably be made to beat the tariffs. The greater part of this forecast is dependent on the relative strength stability of the economy and incomes.

The fiscal outlook

As the administration elect takes office in January, market participants are preparing for rapid change. Many of the proposals will have varying effects on municipal issuers. Another possibility is that certain aspects of the municipal tax exemption or the tax exemption may be called into question. There are some thoughts that there may be a cap imposed of some kind on the tax exemption. Whether SALT is revised in any way remains to be seen. However, offsets will be key to paying for the extension of the tax cuts that are due to expire at the end of 2025. Just how much cutting of the federal budget will be instructive.

In the first instance, we must consider the implications of the cuts to be imposed in the federal budget as espoused by DOGE (Department of Government Efficiency). Many of these proposals will need to be approved by Congress as part of the process. In some instances, certain changes may not require a vote of Congress including new policies for immigration.
Categorical grants to the states will be reviewed category by category. One category where there is good bipartisan support is for transportation spending. We would not anticipate the unwinding of the various programs. Road improvements remain critical to the overall success of the economy. The one area within transportation that we do perceive some risk is in the mass transit component. Historically a Congress with a Republican majority has not been as supportive of mass transit funding. Any changes in this regard would put additional financial pressures on the mass transit entities around the nation.

Although Social Security and Medicare are “off the table,” the same does not appear to apply to Medicaid. There is some discussion that cuts and new requirements may be imposed. Since the states are in a matching program with the federal government for Medicaid, any cuts will directly affect state budgets and cash flows. It will be particularly challenging for the states to “backfill” any federal cuts depending on the size and the scope of said cuts. Since Medicaid is either the first or second highest expenditure in most states, the impact of any proposed cuts will be great.

Another sector that may be affected by the proposed changes is in Higher Education. There had been some discussion in the past that the endowments of private colleges and universities over a certain threshold should be taxed on their gains. Another thought is that colleges and universities that do not have enough apolitical policies in place may be denied certain funding. There is already some discussion about cutbacks in certain areas of research grants.

Housing credits should survive since there has been a critical shortage of housing nationwide, especially at the affordable level. However, we would not expect any expansion of existing credits and programs. Housing also continues to be an aggravating component of inflation.

Directly downsizing (or right sizing) the federal workforce will also have implications for state and local governments. States will collect fewer taxes on the unemployed workers and will have to pay unemployment benefits for said workers among other factors. If the numbers are large enough, consumption and sales tax receipts would be affected by the layoffs.
Each state has a contingent of federal workers. There are some states and cities where there is more of a concentration so one would anticipate outsized effects therein. These changes exclude the military.

Credit concerns overall are not very pressing currently. A slowdown in consumer activity would have an impact. The strength of the equity markets has also contributed to the prospects for strong capital gains for some states.

On the regulatory front, there is the ongoing implementation dialogue about replacing the CUSIP system for municipal bonds. At least at this point, no exceptions are being granted. However, the market is anticipating that there will be less of an emphasis on new regulation or more enforcement coming out of the new administration.
There is an increasing anticipation that there may be some changes to the tax exemption and to the treatment of SALT. We know that discussions are underway but it is not possible to make a definitive prediction at this time.

Market factors

The tone in the markets continues to be positive. Any weakening in equity markets would bolster the fixed income markets. Yields are less of a factor than safety or credit stability. There is a probability that equities will have a tougher year in 2025. As the tone changes and yields remain attractive in fixed income, there should be more activity in fixed income in 2025. Some of the equity gains will find their way to fixed income as volatility becomes the norm.

Despite the presence of elevated supply in 2024, the market has performed well. One would expect the yield curve to steepen over the course of 2025. Once the curve is fully un-inverted, ratios will remain in the range in the 60+% of the equivalent Treasury on the shorter end and around 82% of the equivalent Treasury on the longer end.
If there is a significant pullback on federal funding to the states and the localities, we may experience more short-term borrowing and note borrowing in the coming year.
If education funding is cutback to any significant degree, we may see more volatility in primary and secondary education. The presence of state support programs for those that have them would counteract any effects.

Any changes to Private Activity Bonds and any other select subsector would be expected to have an outsized market reaction initially. Any changes will be imposed from date certain and we would not anticipate any retroactive changes.

Demand for municipals should remain relatively strong as some investors convert some of their hard-won gains into equities to the safety of municipal investments.
Corporates are likely to attract more interest as equities develop more of a volatile pattern.

More participants in the municipal industry continue to seek out technological solutions to reporting and compliance in accordance with MSRB and SEC rules. The cost of compliance continues to be a burden where savings are always sought. Perhaps, over time, issuers will also come to benefit from these advancements.

It is difficult to be very definitive about the various potential assaults on the tax exemption. In the federal budget process, there will be intense pressure to discover offsets to help fund other priorities. The municipal exemption may be viewed as easy to change because the opposition is frequently not as unified as it could be. Extending the 2017 tax cuts at this point is almost a given. A further lowering of the corporate tax rate is not a fait accompli. There will be a robust debate about taxation in the new year.

We look forward to a busy and productive year in 2025 with some of the challenges coming from the unfolding of any new or updated fiscal policies.

More about John Hallacy

John is an accomplished municipal and fixed income analyst, respected and recognized by the industry with over 35 years of experience at major financial firms including S&P’s Global Ratings, FGIC, Bond Investors Guaranty, Merrill Lynch, MBIA, Bank of America, Assured Guaranty, and most recently The Bond Buyer. A leading expert in state and local fiscal affairs. John’s experience includes ratings, insurance, public finance and sell side research.

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