Spreads to the US to widen for most of 2025

Even though market rates have been trending lower into the turn of the year, the dominant theme following the first Fed rate cut in September has been a material ratchet higher in US market rates. This reflected: 1. A firm September payrolls report, 2. An edge higher in some inflation metrics, and 3. The discount and delivery of a Trump election win. This also acted to downsize expected Fed rate cuts, while at the same time macro malaise in the eurozone and elsewhere upsized expected cuts there. Consequently, spreads to the US marched materially higher, coinciding with US dollar strength.

Not only has there been a widening in spreads in the past number of weeks, but spreads are significantly wider versus their 5yr averages. For example, in the 5yr area, eurozone spreads are 50bp wider versus the 5yr average, Canada is 100bp wider, and Japan is 80bp wider, to name a few. The latest absolute spreads are identified in the table below using risk-free rates (where available), where positive spreads are pick-ups to SOFR rates. The question now is where we are going to go from here.

The simple answer is spreads are liable to remain wide as a theme through 2025, with, if anything, a bias to widen further. The central antagonist here is the Trump administration and the reaction to it, from the Federal Reserve and international players of all guises. The Fed’s first issue centres on the stimulative effect coming from proposed tax cuts, which will go through a legislative process in 2025 for full enactment from January 2026. To the extent that the tax cuts include ending taxes on tips, overtime and social security, there is a stimulative effect on the type of consumer that has a high propensity to spend.

An additional concern is the tariff policy. While we remain far from a settled outcome on this, there are some key observations to be made. First, US imports are less than 15% of US GDP. In that sense, they are not dramatically impactful. Second, low import propensity also reduces the size of the impact of tariffs on average economy-wide prices. Third, there is still a likely price rise/inflation effect to be concerned with, and likely something to watch for in 2026, and perhaps through late 2025. We simulate an aggregate price impact of something like 0.5% to 1% on a broad 10% tariff.

This may or may not be 'inflationary', but US market rates will find it hard to avoid discounting the price risk coming from the tariff story. Essentially, we have a tax-cutting/tariff combination that will concern longer tenor rates, specifically to the extent that these price rises eat into the value of a fixed rate coupon paid out on any given bond. This also limits the appetite for the Federal Reserve to cut by too much as we move through 2025. That’s the argument for US market rates remaining elevated. And then there is also the fiscal side to consider (see the previous articles in this bundle for more on this).

From the non-US perspective, there is outsized angst coming from the Trump administration's tariff ambitions and the isolation threat to boot. The eurozone economy is already weak and suffering a degree of political vulnerability e.g. the forced holding patterns ongoing in Germany and France. Meanwhile, Meloni’s right-leaning Italian administration is remarkably looking more like a picture of stability. Fundamentally, eurozone inflation is proving stubbornly sticky, just a tab above where it needs to be. But the European Central Bank will be minded to cut rates by enough to ensure no return to a dis-inflationary spiral that might come from macro malaise. That continues to argue for far more rate cuts from the ECB than from the Federal Reserve, in turn keeping the spreads differential wide.