Eric Souders, Director and Lead Strategist, Global Unconstrained Fixed Income Team, Payden & Rygel, writes on 2025’s bond markets.
A long time ago in a galaxy far, far away…
The forces shaping markets are at the confluence of economic, fiscal, and political factors. Inflation dynamics remain in flux, a new Treasury Department strategises the balance between fiscal and monetary conditions, and Donald Trump’s second administration all introduce important dimensions to policy and growth.
The confluence of factors will play a pivotal role in shaping the trajectory of financial markets and determining whether balance can be restored to the bond market galaxy as the Bond Wars saga unfolds in 2025.
Episode One: Inflation is dead – a new hope
For years, the forces of light and optimism have prevailed. Asset prices have tested all-time highs, growth has been robust, and the U.S. labor market remains healthy. However, the dark side of inflation, though tempered, continues to cast a shadow threatening to destabilise the balance.
At the heart of Episode One stands Jerome Powell and the Federal Reserve. Their mission is to preserve the forces of light in the economy while preventing the dark inflationary forces from wreaking havoc in the bond market galaxy.
Timeframe informs perspective
In most battles between light and darkness, each side appears to gain the upper hand at various points before a definitive conclusion is reached. This struggle in financial markets has been no exception in recent quarters. The forces of light appeared victorious in Q3 2024, when inflation was declared dead, only to succumb to the dark side in Q4 2024 as inflation reemerged and the new year approached.
The timeframe can meaningfully influence the audience’s perspective on whether light or darkness will prevail. Various measures of annualised inflation over a three-month period suggest the dark side is gaining strength, while those measures annualised over a six-month period suggest the forces of light may still hold control.
Shifting market forces
At the start of 2025, Jerome Powell and the Fed face a mix of structural and cyclical forces that challenge forecasting and render conventional monetary policy less effective in their quest to ensure forces of light prevail. For example, cyclical forces such as normalising supply chains, productivity green shoots, and contained commodity prices typically support more stable prices.
Conversely, structural forces like deglobalisation, rising geopolitical tensions, and higher fiscal deficits are often inflationary. To complicate matters further for Powell and the Fed, the Trump administration introduces additional forces to consider, such as tariffs, immigration policy, and pro-business measures.
Episode Two: The Treasury strikes back
The battle between light and darkness continues in Episode Two with the arrival of Scott Bessent, the newly appointed Treasury Secretary in the Trump administration and former Chief Investment Officer of Soros Fund Management. Thus far, financial markets have received Bessent’s appointment with optimism, given the expectation that his policies will include pro-growth and fiscally pragmatic measures.
However, over the last several quarters, Bessent has suggested a meaningful shift in policy is necessary to guide the US economy toward a more sustainable trajectory. A sustainable economy is one that withstands business cycle volatility, achieves price stability, and fosters robust real wage growth. It ensures equitable opportunities across demographics, contains inflation, and decisively counters the underlying dark forces.
Slowing activity in Q3 2023 and Q4 2024 caused markets to shift to a Fed-cutting cycle, and the Fed reinforced the shift by signaling easing measures. As a result, interest rates declined, asset prices rose, and financial conditions eased, eventually causing a growth impulse and rising inflation measures. This feedback loop later forced the Fed to adjust its dovish stance. Bessent will look to break this loop by tightening financial conditions through tools at his disposal, such as debt issuance.
Episode Three: The return of the red wave
Lower corporate taxes, reduced regulation, and the strategic use of tariffs as a negotiating tool defined the economic playbook. Fiscal discipline took a back seat while positive animal spirits swept through corporate America. Capital expenditures and M&A activity surged, hiring accelerated, consumption increased, and growth prospects improved. This combination fuelled a surge in asset prices, propelling them to new highs. This was the central storyline of Trump’s first presidency.
Trump’s victory in 2024 was largely driven by voters prioritising the economy, particularly inflation, over asset appreciation or economic growth. The ideal outcome for the new administration would involve a balanced approach, combining growth-oriented measures like lower taxes and deregulation with policies aimed at tightening financial conditions and containing inflation. Whether the red wave can deliver on a key campaign promise to the middle class is yet to be seen.
The concluding question
The bond market galaxy is at an inflection point. Forces of light have been strong in the last two years, with solid growth, stable employment, and record-high asset prices. However, the dark side lingers as inflation remains elevated and bond market volatility is too high.
The question remains whether the new collation within the red wave helmed by Federal Reserve Chair Jerome Powell, Treasury Secretary Scott Bessent, and President Donald Trump, can vanquish the dark forces of inflation and fulfill the government’s oath to the American people or if the scales will tip, reigniting the eternal battle between the forces of order and chaos lurking in the bond market galaxy.
May the force be with you!
