Macro: growth dynamics remain uneven across regions
Growth dynamics remain uneven across regions. The global macro picture since COVID has been all about the US. Investors have been laser-focused on the speed of the US recovery, the aggressiveness of its central bank, and the exceptionalism of its tech firms. The US economy is still converging to trend growth from higher…. China is disappointing due to depressed domestic consumption and insufficient policy stimulus, with sub-5% growth looking more and more likely in both 2025 and 2026, while the EZ faces another year of lacklustre sub-1% growth, although the German elections and the more stable political situation in France could still provide some tailwinds. The EU household savings rate has remained elevated due to the fading energy crisis, record-low unemployment, growing real wages, and a declining debt service ratio. There is, therefore, clearly room for consumption to rise.
The global disinflation trend continues, but inflation still has claws
Global inflation continued normalizing towards long-term averages. Goods inflation stabilized somewhat faster than services, which remains, with few exceptions, stubbornly high. The last mile in the disinflation process is always the toughest, and the new set of US policies will bring some upside risk to the table. We see core PCE inflation in the US stuck in a 2.5/3.0% range in 2025-2026 (2.7% YoY as of January’25), instead of drifting closer to 2%.
We would not read too much in the January US CPI data. The higher-than-expected increase was driven by categories prone to beginning-of-year price resets, while the remaining categories that are neither volatile nor prone to resets, including rents and OER where in line or even below estimates. Thus, we view the January increases as a one-time price level shock, rather than a persistent trend.
Risks: our views on exogenous shocks
There are some key known risks to the outlook and we will need to revisit the outlook for the year on a
regular basis. Most risk factors stem from the US (trade wars, inflation, consumer uncertainty) and could affect other markets significantly. The main exception is political risk, with Europe, particularly France and Germany, in flux. Despite the increase in US political uncertainty, which makes it difficult for companies to make long-term plans until they get more clarity on potential structural changes in their operating conditions and is also a headwind for US growth, we have not seen any heightened market volatility, as the options markets have been relatively quiet, the VIX and MOVE indices are not significantly higher, and CDX implied volatility is still low.
The dominant view right now regarding tariffs is that this will remain an ongoing risk to sentiment, although it is unlikely to have any real consequences in terms of Fed expectations until we see either growth or inflation impacts in the data, which is unlikely to happen until probably sometime in 2Q25, at the earliest. Although Trump has said that tariffs on the EU “will definitely happen”, we would assume a deal can be struck with Europe agreeing to buy more US LNG, which, in any case, is probably in their interest to rebuild gas storage after a colder-than-average winter, which could lead to more headline volatility.
Additionally, the tariffs on Mexico and Canada have only been delayed for 30 days, not cancelled, which means that we could see a repeat episode at the start of next month. Finally, the USTR has been tasked with preparing a report on ‘unfair trade practices’ by early April, with the risk that this could result in further tariff threats.
Any exogenous shocks (i.e., DeepSeek) that leads to a correction in asset prices could negatively impact
consumer confidence to the point of inducing households to reduce consumption enough to drive the economy into a recession, validating the correction in asset prices.
And what if the Fed hikes?
Another exogenous shock would be the Fed hiking in 2025. In this regard, The SOFR options market now implies
a 25% chance of higher rates (above 4.5%) by YE2025 (compared with 10% before the US elections and hence
pricing in a scenario of significant inflation surprises over the next few months and a 25% probability of the policy rate being above 5% by YE26 (this would entail three 25bp hikes from spot). Needless to say, the start of another hiking cycle could be quite negative for credit and defaults, as seen in the 1980s. Furthermore, the market is assuming a hike would be the beginning of a cycle, not just a one-off occurrence.
The most likely path to rate hikes would be evidence of increasing inflationary pressure, with a sustained acceleration across a range of goods and services, and evidence that longer-term inflation expectations are becoming unanchored (U.Mich 5-10Y median inflation expectations above the 2.8-3.2% range for more than two or three months), overheating activity and tightening labour markets, together with an array of indicators that demand is outstripping aggregate supply, thereby threatening the achievement of the Fed’s 2% inflation target over the medium term. Sustained increases in longer-term inflation expectations would bolster the case for, or even be an independent trigger of, hikes. For instance, if the SEP median projections for the core PCE at YE2025 reached or surpassed 3.0%, 50bp or more above the current consensus view, this might considered be a reasonable trigger.
IG spreads would widen significantly in a stagflationary environment, and for credit we think spreads would widen 25-30bp in investment grade and 100-110bp in high yield, assuming growth remains strong, in line with the "taper-tantrum" in 2013, when the 10Y UST rose by over 100bp. US spreads could widen towards or through their long-term medians if hikes are accompanied with slower growth but still remain out of recessionary territory (130bp in IG, 450bp in HY since 1990).The US neutral rate would then be reviewed higher to 3.75-4%.
The risk for financials would mainly affect smaller or less diversified issuers. If rate hikes are driven by
persistent inflation, higher provisions and credit costs could trigger increased CECL reserving at lenders. Fixed asset devaluation could pose risks to banks'; securities portfolios, but capital buffers have increased since 2023, providing some protection against MTM in a potentially higher interest rate environment. Higher rates would also pressure residential mortgage production and could increase LTVs on CRE loans.
Central banks: a year of divergence
Central banks likely to become less synchronised: we expect global inflation to continue converging
asymmetrically towards inflation targets, although the last mile is always the hardest, particularly in the US. In a shift from 2024, we expect more divergence in policy rates as DM central banks could face different risks to inflation and growth, both on the domestic and external fronts. But these projections are subject to an unusually high degree of uncertainty. The open debate is how fast should the ECB move to the neutral rate be and its level.
Spread dynamics: the compression trend continues
The extreme compression dynamics that dominated in 2024 in three main dimensions: rating, sector and
seniority. as investors chased yield, continues into 2025. Most parts of European credit are inside the prior tights of mid Dec, AT1s and T2s in particular. Markets in general have brushed off tangible tariff headlines and meaningful AI-led equity volatility, a testament to strong demand, but pointing to a degree of complacency.
First, High-Yield spreads are significantly compressed relative to Investment Grade, leaving little room for further compression.
Second, Financials have consistently outperformed Non-Financials since the last banking crises stemming
from Credit Suisse and Silicon Valley banks in March 2023. The Fin/Non-Fin senior spread gap is at its lowest
level since January 2022, at below 3bp. Banks continue to be the most preferred sector in IG credit, despite the
spread compression between financial and non-financial names reaching lows. Indeed, investors feel comfortable
about banks’ fundamentals and prefer to keep their exposure rather than buying other sectors with weaker trends. Valuation is somewhat stretched, but we nevertheless acknowledge that the short-term momentum looks more favourable for extending compression of the Fin/Non-Fin spread in 2025 until we see more evidence that the macro-outlook in Europe is not as bad as the market fears and the initial salvo of the new Trump administration’s tariffs has dissipated. We are OW SNP vs. SP debt, as the former could come under pressure at some point from the significant widening of rates and rate-like products in 2024.
The main risks to the financials sector now look to be of an exogenous nature linked to geopolitical and
sovereign risks. Though likely to generate episodes of volatility and sentiment overhang, we consider these to be
risks that are less likely to pose acute stress to individual issuers, and accordingly this does not preclude continued engagement with subordinated risk more broadly. Endogenous risk to the sector, apart from some very specific cases of CRE exposure, have simply not manifested.
Third, subordinated bonds continue to massively outperform Senior bonds, pushing spreads to historically
tight levels. The relative weakness of the so-called core European economies is increasingly apparent in credit markets as a negative peripheral premium – with Spanish and Italian credits persistently tight vs. core issuers. European bank AT1s (and T2s) rallied strongly in 2024, with AT1s among the best-performing categories within credit. Bank capital spreads are reaching close to 2021 tights and recovering to levels prior to the CS AT1 write-down. The extension risk premium for AT1s has fallen significantly in the 2024 rally. While extension risk is not generously priced either, 2025-2026 have some of the better vintages up for call in terms of reset spreads.
We think this strong performance has been driven by recognition by investors of the strong fundamentals of the
European banking sector, which has witnessed significant improvements in profitability, bolstered by higher interest rates, whilst still experiencing benign asset quality developments and less extension risk due to the use of tenders and expected calls. Although NPLs will be closely monitored in the event of a recession, investors expect European banks’ fundamentals to remain solid, consolidating the improvement seen in recent years.
Interest rate products, such as EGBs, SSAs and covered bonds, which are generally cheaper to own than
investment grade credit from a Solvency II capital or RWA perspective for insurers and bank treasury desks and that sit between Bunds and IG credit, came under pressure in the second half of 2024, driven by both OAT-Bund spread widening and the move in Bund swap spreads, but they have shown a more solid performance in 2025, with a tightening trend across the board in the new primary deals, as the French news flow has turned more positive and the critical Bund-swap spread has stabilised. As a result, the ‘floor’ on spreads is getting lower as these other assets have started to rally. Covered bonds have also rallied by 4-5bp since the start of the year, allowing bank senior preferred to maintain a spread cushion vs. covered despite also registering a strong performance. Taken as a whole, if everything else continues to rally, then there is nothing stopping investment grade from continuing to grind tighter.
Attractive all-in yields, technicals & innovations further support credit spreads
Investors need to maintain an exposure to yield-generating bonds, with IG subordinated debt - particularly hybrids and AT1 instruments – as a way to capture higher returns without taking on full HY risk.
Credit market innovations – such as portfolio trades, and fixed-maturity credit funds – increase the weight of positive technicals across the market, further squeezing credit spreads. Over time, the credit market's appetite for aggressively buying dips is growing. There is a growing detachment between macro events and credit spreads (France and the Red sweep in the US).
Credit spreads have decoupled from their previous relationship to rates volatility and are becoming less sensitive to macro headlines, in particular to political noise that lacks a clear and direct link to credit issuers.
The technicals should remain very strong in 2025. 2024 saw record inflows into euro investment-grade funds,
comfortably beating the previous high in 2016 and, with yields still attractive compared with recent history, we see
little reason for this to change. We thus anticipate continued strong buying. If curves steepen on policy cuts, we could even see increased as investors move out of cash equivalents and into slightly longer-dated products.
Two contrasting views on credit spreads: G-spread vs. ASW
How tight or expensive are credit markets at this stage depends to a large extend on how you look at it. On a benchmark spread basis, we are at the tightest level since early 2022 at 104bp, and, while there may still be a little way to the floor, with even tighter levels of 94bp reached in 2021 and 82bp in 2018, there does not seem to be much value left. On the other hand, on an asset swap basis - i.e. measured against the swap curve - spreads are at the wider end of the range from the past year at 92bp, more than 12bp wider than the 2024 tights.
7Y-10Y EUR IG spreads of 115bp sit at just the 16th percentile now (looking back since 2010). However, Bund-swap spreads in Europe are back to record low negative levels again (partly driven by large government bond supply volumes). As a result, 7-10Y IG Z-spreads are almost at identical levels (112bp, 57th percentile) and hence much more attractive for swap-based investors such as bank treasury desks.
The difference, of course, is explained by the collapse in swap spreads - i.e., swap yields minus Bund yields - this year, with the swap curve now trading in line with or even through the sovereign curve. The reasons for this are complex but anecdotally include: i) banks receiving in swaps to ‘lock-in’ their net interest income at the highs, which pushes down swap yields; ii) upward pressure on Bund yields from sovereign deficit financing and ECB QT; and iii) at the very short-end, general collateral repo (GC) rates moving above ESTR due to excess collateral and a bid for cash from banks in the absence of the ECB TLTRO.
There is no single and unique correct measure of spread. However, we do generally believe that benchmark
spreads are more relevant to the majority of investors, as ultimately, they are buying credit for yield and comparing the opportunity cost against other fixed income assets they could buy, which in most cases means sovereign bonds.
Nonetheless, wider asset swap / z-spreads do matter to some segments of the market, including: i) dealers, who typically quote on z-spread; ii) bank treasury desks; iii) foreign investors buying on a fully swapped basis; and iv) issuers, with primary typically quoted against mid-swaps, and, again, particularly when comparing value across
currencies for issuers with a swap programme.
Our Spread targets & ideas for 2025
No credit market is currently pricing a recession. Euro IG at 104bp on a G-spread level versus recession pricing of 155bp/160bp; and EUR HY is a lot further away: BBs are at 210bp vs. 550bp recession pricing. In this regard, we see EUR IG spreads tightening to 95-100bp (G-spread) by YE2025, while we see EUR HY NFC trading slightly wider vs. current spread levels, 350-365bp (G-spread) vs. 323bp as of now.
Regarding US credit spreads, IG spreads at multi-decade tights would imply investment grade spreads to trade
slightly wider to 100-105bp (vs. 96bp as of early February’25, +4bp wider YtD) and for high yield to finish 2025 in the 280-300bp range (vs. 258bp now). We see slowing growth and inflationary policies pressuring spreads, but the high- quality bias of the index and sustained demand for yield should keep it from spiking significantly wider. All-in US IG yields comfortably above the 5% mark should continue to draw investors who have largely become spread agnostic and should allow spreads to tighten further should recent sentiment and yields persist.
Safe and Senior credit is cheapest across EUR IG. Virtually everywhere we look within IG we see asset class compression in defiance of the rates rally and slowdown risk. Cash price vs. spread product is exceptionally expensive, as is Cyclical vs. Non-Cyclical, and BBB vs. single-A. IG should be an early beneficiary of the ECB’s largesse. However, HY could feel headwinds from trade uncertainties and increased supply in 2025.
- We like longs in as vs. BBBs given compressed spreads. In HY we favour BBs over Bs.
- We still see merits of being long sub debt, both financials and hybrids, in 2025, on lower ECB rates fostering a “search-for-yield” trend.
REITs were the outperformers in 2024, driven by the rate-cutting cycle, although later at odds with a growth scare and, as such, we recommend caution on buying the dips here. Further performance in REITs is not a given due to the potential limitations for high rates and disinflation. Rising rates would hurt interest coverage ratios, the extent of property valuation recovery expectations and sentiment. However, termed-out debt profiles provide a degree of protection. We think REITs have become a place for being selective at the single-name level, as the risk in rates is for fewer cuts than currently priced in and, in our view, the risk-reward in REITs remains unattractive. As a sector allocation, we would now prefer to reduce exposure.
We prefer Europe to the US for investment grade and high yield. Given relative valuations and diverging macro backdrops in terms of growth trajectories, inflation, and central bank policies. Potential increases in USD hedging costs also support this. In fact, EUR IG spreads have been a notable outperformer versus USD IG YtD and the EUR vs. US IG spread gap is at three-year tights, as the Fed grapples with inflation uncertainty, but the ECB sticks to its rate-cutting script. After a quick move wider after the US election, strong technicals have re-asserted themselves in the EUR IG market and spreads have compressed accordingly, with the spread differential between both markets falling from a wide of 30bp in late November to 16bp currently.
- Investors are still overly bearish on Europe and we like the unravelling of this bearish consensus. The main risk to the YtD outperformance of both the EUR and GBP credit markets vs. the USD one is a trade war with Europe, which would be more consequential for spreads than Canada/Mexico/China. On the other hand, a further decline in French sovereign risk or the rising hopes of a ceasefire in Ukraine, with the US apparently close to presenting its peace plan, could potentially extend the outperformance of EUR credit. In this regard, a potential end to the hostilities between Russia and Ukraine, with a period of relative calm, potentially lower energy prices and a potential reconstruction boom in Ukraine, could boost the economic outlook for the Eurozone, particularly for the German economy, supporting a rebound in the European economic activity from 2H25.
- As an example of the different dynamics between EUR and USD, €-AT1s overlaid with a 3-months FX forward, would usually trade with a premium to $-AT1s - driven by generally higher quality of banks issuing $-AT1s, but also the broader investor base for $-AT1s. Recently, however, this €-AT1 premium has evaporated.
- We think part of the reason for this is concerns about US rates volatility – and the risk of realising a positive rate- spread correlation in a sell-off, which appears to be less of a risk in Europe. We do not see the relative $-AT1 weakness as a general sign of concern around European banks. In fact, smaller and typically lower-rated banks, which had exclusively accessed the €-AT1 market, have significantly outperformed their larger peers.
We expect a steady performance for corporate hybrids in 2025. Indeed, corporate hybrids look attractive versus LT2, which are their closest proxy in risk-reward terms within the hybrid capital universe. Corporate hybrids also remain priced roughly in line with BB corporate senior bonds, thus offering "HY-esque" returns on robust IG names (non-cyclical issuers, like Utilities and Telcos, account for c.70% of the corporate hybrids asset class).
Overall, we consider that the risk-reward offered by corporate hybrids remains a good compromise within the credit universe, particularly versus the other high-Beta segments. We believe that 2022-2023 stress peaks have tested the corporate hybrid asset class and demonstrated that hybrid-specific risks (extension risk, deferral risk, subordination) remain structurally low as long as the issuer is IG-rated and priced accordingly in senior.