Investment Outlook February 2025: Challenging times in government bond markets

Recent volatility in government bond markets indicates that investors are struggling to navigate short-term inflation and interest rate risks, along with longer-term issues surrounding mounting US public debt. While the equity market is supported by favourable fundamentals, investors still need to consider a range of portfolio diversifiers to protect against different market downside scenarios. If the global economy is now under a new regime of inflation volatility and rising government debt, gold should be included in portfolios.

Looking into the abyss of mounting US government debt

March will mark the 150th anniversary of the discovery of the Mariana Trench, the deepest undersea trench in the world. During a routine depth sounding in the Pacific Ocean in 1875, sailors on the HMS Challenger accidently stumbled across something quite extraordinary. The weighted rope they were using plummeted to new depths until it finally reached a bottom nearly five miles down.

In reverse, a similar comparison can be made today over the trajectory of US government debt, which continues to reach new highs. The bi-partisan Congressional Budget Office (CBO) estimates that debt held by the public will exceed its previous peak of 106% of GDP in 1946 by 2027 and go onto reach a record 122% by 2034.¹ Given recent bond market volatility, it seems investors are searching into the abyss to find an appropriate yield to capture risks associated with cyclical changes in inflation and interest rates on top of accumulating debt.

Equity investors appear sanguine about bond market volatility

The good news for equity investors is that the fundamentals of healthy economic growth expectations, rising profit margins and the powerful artificial intelligence (AI) theme have lifted the market higher, ignoring the uncertainty coming from the bond market, for the time being.

Cyclical risks from interest rates and inflation also appear manageable for equity investors. The Federal Reserve (Fed) is expected to cut its base interest rate by at least 50 basis points (bps) from its current level to under 4% at the end of 2025.²

Importantly, inflation appears to be under control in the short term. The Fed’s favoured measure of annual inflation, the personal consumption expenditures (PCE) deflator, slowed to 2.8% in November, not far off the 2% target rate.³ Getting close to that target should reduce the potential for the Fed to reverse track and raise interest rates.

However, a big unknown for investors is how to incorporate a potentially unsustainable path of rising public debt into treasury yields. Academics find that a higher debt to gross domestic product (GDP) ratio generally results in a small rise in long-term rates. Using CBO projections up to 2034 as our baseline and academic literature, our calculations show that increased government debt could raise long-term interest rates by around 50bps.⁴ This analysis suggests that mounting public debt is not an insurmountable problem for investors.

Nevertheless, there are warnings signs. For instance, since the Fed began to cut interest rates in September, the US 10-year treasury yield has risen by over one percentage point to 4.7%. In contrast, the average of the last six periods of monetary loosening saw yields move lower by this stage of the rate cutting cycle.⁵

Part of this move can be explained by changing expectations for interest rate cuts: in September the futures market expected the Fed to cut interest rates to 3% in 2025, whereas now it expects rates to finish the year at around 3.8%. But concerns around escalating debt could also be contributing to higher yields. For example, the additional cost of long-term government borrowing (the term premium) is currently at its highest level for a decade. This suggests the private sector is finding it more difficult to absorb increased bond supply.

The good news for equity investors is that the fundamentals of healthy economic growth expectations, rising profit margins and the powerful artificial intelligence (AI) theme have lifted the market higher, ignoring the uncertainty coming from the bond market, for the time being.

Cyclical risks from interest rates and inflation also appear manageable for equity investors. The Federal Reserve (Fed) is expected to cut its base interest rate by at least 50 basis points (bps) from its current level to under 4% at the end of 2025.²

Importantly, inflation appears to be under control in the short term. The Fed’s favoured measure of annual inflation, the personal consumption expenditures (PCE) deflator, slowed to 2.8% in November, not far off the 2% target rate.³ Getting close to that target should reduce the potential for the Fed to reverse track and raise interest rates.

However, a big unknown for investors is how to incorporate a potentially unsustainable path of rising public debt into treasury yields. Academics find that a higher debt to gross domestic product (GDP) ratio generally results in a small rise in long-term rates. Using CBO projections up to 2034 as our baseline and academic literature, our calculations show that increased government debt could raise long-term interest rates by around 50bps.⁴ This analysis suggests that mounting public debt is not an insurmountable problem for investors.

Nevertheless, there are warnings signs. For instance, since the Fed began to cut interest rates in September, the US 10-year treasury yield has risen by over one percentage point to 4.7%. In contrast, the average of the last six periods of monetary loosening saw yields move lower by this stage of the rate cutting cycle.⁵

Part of this move can be explained by changing expectations for interest rate cuts: in September the futures market expected the Fed to cut interest rates to 3% in 2025, whereas now it expects rates to finish the year at around 3.8%. But concerns around escalating debt could also be contributing to higher yields. For example, the additional cost of long-term government borrowing (the term premium) is currently at its highest level for a decade. This suggests the private sector is finding it more difficult to absorb increased bond supply.

The bond market could be tested further if President Donald Trump and Republicans in Congress make individual income tax cuts permanent as planned. That’s because the US budget deficit will widen by 1.3% points of GDP from the CBO’s baseline of 6% in 2026 and increase the rate at which debt accumulates.⁶

While it is inconceivable that the US government would not pay back the money it borrowed (i.e. an actual default), it could stealthily ‘default’ by allowing higher inflation to lift nominal growth and reduce the debt as a share of the economy. It happened in the initial years after the end of the second world war in 1945. War production switched to pent-up consumer demand at a time when the Fed was committed to maintaining low interest rates, with an implicit cap of 2.5% for long-dated bonds, until the Fed-Treasury Accord in 1951. In this time consumer prices index (CPI) inflation accelerated to top-out at 18.9% in January 1947.⁷ Given that inflation reduces the real value of outstanding debt it essentially imposes losses on creditors in real terms.

Looking beyond rising debt risk, bonds can provide portfolio insurance to investors against idiosyncratic risk in the equity market, such as over-capacity concerns in the AI space. For example, the release of DeepSeek-R1, a Chinese developed Large Language Model (LLM) drove US tech stocks down towards the latter part of January, while government bonds returns rose. It seemed that investors were concerned about whether DeepSeek could undermine the AI theme by offering an LLM at a fraction of the cost of others, such as the American developed ChatGPT, and switched into bonds.

Looking for portfolio diversifiers amid long-term inflation concerns

Government bonds have typically been used by fund managers to smooth out portfolio return volatility when equities have come under pressure. They typically perform best when economic growth slows, for instance during a recession. Bonds should do so again if the global economy takes a turn for the worse.

In contrast, bonds perform less well in inflationary environments. For instance, when the Fed turned hawkish in response to higher inflation in 2022, both global equities and government bonds sold-off, resulting in a positive correlation between the two assets.

Given record levels of public debt in the US, owning government bonds may incorporate a new risk related to another potential stealth ‘default’ in the future. Arguably, investors may be pricing this risk into the bond market. Bank of America argues that the US 10-year Treasury market has entered the sixth year of a third great bond bear market over the last 240 years. The previous two lasted 21 years (1899-1920) and 35 years (1946-1981).⁸

If the global economy is going to see more inflationary periods, gold has a long-term track record in beating inflation. Since the 1930s, the gold price has risen 90-fold in US dollar terms, whereas US consumer prices are up 18 times.⁹ Gold could offer an alternative way for investors to protect against equity downside risk in an inflationary environment.

Managing bullion risk in a golden age

The shortcoming for gold is the opportunity cost of owning a zero-yielding asset when real yields (adjusted for inflation) have gone up. Historically, whenever real yields rose, the gold price tended to fall and vice versa.

However, this statistical relationship broke down when Western governments applied financial sanctions against Russia following its invasion of Ukraine in February 2022. This action catalysed a significant step-up in central bank gold purchases in emerging markets (EMs) - see our May 2022 Investment Outlook: Markets are trying to figure out how to balance slowing growth with rising interest rates.

EM official gold purchases could reflect lower confidence in the ability of the US to manage the US dollar financial system and the fear of secondary sanctions. It also suggests that EM central banks are gold price-insensitive and are more concerned about a return of their investment, rather than generating a return on their investment. Hence, interest rates have become less influential on the gold price. The fact that the gold price has risen simultaneously with the dollar, which makes largely dollar-denominated bullion more expensive, suggests a paradigm shift is underway - see our May 2024 Investment Outlook: Diversifying the diversifiers amid geopolitical tensions.

In this ever-evolving macroeconomic environment, investors should consider holding a range of portfolio diversifiers to hedge against different risks. Bonds could continue to protect investors against negative growth outcomes and idiosyncratic risks in the equity market. Whereas gold can serve as a hedge against inflation and potential volatility from increasing government debt levels. Either way, investors face a voyage into the unknown amid mounting US outstanding public debt.

Sources

1. CBO.gov, An Update to the Budget and Economic Outlook: 2024 to 2034, 18 June 2024
2,3,5,7. LSEG, Evelyn Partners
4,6. Evelyn Partners
8. 13D Global Strategy & Research, What I learned this week, section 3, 16 January 2025
9. Omfif.org, Gold and the new world disorder, December 2024