Bond Wars – Unconstrained Bond Strategy 2025

Episode One:

Inflation is Dead – A New Hope
For years, the forces of light and economic optimism have prevailed. Asset prices have tested all-time highs, growth has been robust in both nominal and real terms, and the labor market remains healthy despite some normalization. However, the dark side of inflation, though tempered, continues to cast a shadow threatening to destabilize the balance. At the heart of Episode One stands Jerome Powell and his colleagues at 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. How they navigate this challenge will hinge on a few key factors. 

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. As the page turns to 2025, the timeframe can meaningfully influence the audience’s perspective on whether light or darkness will prevail. Various measures of annualized inflation over a 3-month period suggest the dark side is gaining strength, while those measures annualized over a 6-month period suggest the forces of light may still hold control (see charts on page 2). Since the December 2024 FOMC meeting, Jerome Powell and the Federal Reserve have signaled unease regarding the recent rise in inflation measures, subtly shifting their focus from labor and growth to containing inflation. 

Shifting Market Forces
Market forces across the bond market galaxy can shift in both cyclical and structural ways. Cyclical shifts can occur rapidly, rendering forecasts outdated, increasing uncertainty, and driving price volatility across financial assets. Structural shifts typically take longer to unfold and require time to unveil unexpected plot twists. 

At the start of 2025, Jerome Powell and the Federal Reserve face a mix of structural and cyclical forces that challenged forecasting and rendered conventional monetary policy less effective in their quest to ensure forces of light prevail. For example, cyclical forces such as normalizing supply chains, productivity green shoots, and contained commodity prices typically support more stable prices. Conversely, structural forces like deglobalization, rising geopolitical tensions, and higher fiscal deficits are often inf lationary. To complicate matters further for Powell and the Fed, the incoming Trump administration introduces additional forces to consider, such as tariffs, immigration policy, and pro-business measures. The outcomes associated with the combination of these forces can be quite wide-ranging and will require the Fed to carefully assess which factors to prioritize as forecasts are determined, and policy is implemented.

Although inflation has declined materially over the medium term, a shorter-term perspective suggests it may not be dead yet. Meanwhile, shifting market forces will likely make forecasting more challenging as inflation volatility rises. As a result, the protagonists at the Federal Reserve may need to “use the force” to keep monetary policy tighter than previously expected to maintain order in the bond market galaxy and preserve their legacy.  

Episode Two:

The Treasury Strikes Back
The battle between light and darkness continues in Episode Two with the arrival of a new protagonist. Enter Scott Bessent, the newly appointed Treasury Secretary in the Trump administration, succeeding Janet Yellen. Bessent, a legendary macro investor and former Chief Investment Officer of Soros Fund Management, worked alongside investing titans George Soros and Stan Druckenmiller. Renowned for his expertise in global macroeconomic trends, Bessent’s appointment marks a notable shift at the Treasury Department from Yellen’s background in academia and public policy to Bessent’s deep roots in the private sector and financial markets. Thus far, financial markets have received the Bessent appointment with optimism, given the expectation that his policies will include pro-growth and fiscally pragmatic measures. While this combination will play an important role during his time at the Treasury, other pieces to the Bessent policy puzzle might prove crucial as the Bond Wars unfold.

Over the last several quarters, in both public interviews and written commentary, Bessent has suggested a meaningful shift in policy is necessary to guide the U.S. economy towards a more sustainable trajectory. A sustainable economy is one that withstands business cycle volatility, achieves price stability, and fosters robust real wage growth. It is an economy that ensures equitable opportunities across demographics. Most critically, it is an economy where inflation is contained, and the underlying dark forces are decisively countered. Although Bessent’s objective in Episode Two aligns with Powell’s in Episode One, namely in containing inflation, the strategies by which that goal is achieved could diverge significantly and have a material impact on financial markets.  

Financial Conditions

Why is Bessent arguing that financial conditions are too easy and for higher rates as a result? This is seemingly at odds with the general market consensus that monetary policy is restrictive and that the Federal Reserve should reduce its policy rate to prevent deterioration in the labor market and a slowdown in growth. The answer lies in the notion that the U.S. economy today is less sensitive to Federal Reserve policy and the level of front-end interest rates compared to prior cycles. This is because the current cycle has been driven by income and wage growth rather than debt, augmented by healthy balance sheets across U.S. households and corporations. Notably, U.S. household debt relative to GDP is at the lowest level in 15+ years. U.S. Corporate net interest payments as a share of after-tax income are at the lowest level in 60+ years. As a result, traditional measures that inform the appropriate level of monetary policy, like the Taylor rule (a guideline that adjusts interest rates based on inflation and economic output gaps), might be less useful in the current environment.

The U.S. economy exhibited signs of slowing activity and declining growth expectations in Q3 2023 and Q3 2024. In both periods, market expectations shifted sharply toward a Fed cutting cycle, and Jerome Powell reinforced this shift by signaling easing measures were imminent (see chart above). As a result, interest rates declined, asset prices rose, and financial conditions eased. This created a growth impulse while measures of inflation subsequently rose to levels inconsistent with the Fed’s target. This feedback loop later forced the Fed to adjust its dovish stance as interest rates moved higher. As Episode Two unfolds, Bessent might look to break this feedback loop by tightening financial conditions with the tools at his disposal.

Approach to Debt Issuance

 Bessent’s primary tool as Treasury Secretary is the department’s approach to debt issuance (U.S. Treasuries). He has voiced strong opposition to Janet Yellen’s decision to rely on short-term debt issuance during a non-recessionary period, arguing that it has contributed to easier financial conditions and undermined the sustainability of the U.S. economy. As a result, a plausible outcome in Episode Two is a more balanced approach to debt issuance, with a greater reliance on long-term debt. This shift would tighten financial conditions as asset prices, particularly equities and real estate, are more sensitive to longer-term interest rates. The likely effects would include reduced demand, slower growth, and lower inflation. If these conditions materialize, Jerome Powell and the Federal Reserve would have justification to reduce interest rates, simultaneously alleviating the U.S. federal interest expense burden. 

The plot sequence in Episode Two is critical: long-end interest rates rise, financial conditions tighten, demand slows, and the inflationary forces of darkness are subdued when the Treasury Strikes Back.

Episode Three:

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 fueled a surge in asset prices, propelling them to new highs. This was the central storyline of Trump’s first presidency and the red wave in 2016. Will the Return of the Red Wave follow a similar plot and reach the same conclusion as the original? The clues may lie in today’s economic starting point and incentive structure for President Trump relative to 2016.

The Economic Paradox: Inflation vs Growth
Growth in the U.S. has been above 5% in nominal terms for seven out of eight quarters and above 2.5% in real terms for seven out of eight quarters. Asset prices, including U.S. equities and housing prices, are at or near all-time highs, while credit spreads are near 20-year lows. In summary, the U.S. economy is doing well and does not need more growth, with some arguing it could even benefit from less growth (see charts on page 5). Donald Trump’s victory in the 2024 elections was largely driven by voters prioritizing the economy, particularly inflation, over asset appreciation or economic growth. While growth figures and a healthy labor market suggest the economy is not struggling, prevailing levels of inflation which are well above those experienced in 2016, likely weighed more heavily on voters’ minds (see chart on page 5).

The Administration’s Strategic Balancing Act

The ideal outcome for the Trump Administration in the Return of the Red Wave would involve a balanced approach, combining growth-oriented measures like lower taxes and deregulation with policies aimed at tightening financial conditions and containing inflation. Augmenting these balanced measures with wins in hot-button voter issues like immigration and foreign policy could help dampen the lack of excitement associated with a benign environment for asset prices during the first year of the new administration. The question remains whether the new coalition within the red wave can successfully lower the dark forces of inflation at the expense of growth, making good on a key campaign promise to the middle class and restoring order to the markets.

Conclusion

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. Order must be restored as the key players in this saga aim to complete their various objectives.

The Payden Unconstrained Bond team envisions a potential plot twist in the Bond Wars, where bond yields must rise before they can fall. A rise in yields, particularly    in longer-term maturities, would tighten financial conditions and temper growth expectations. As a result, the Unconstrained Bond team prefers less exposure to the long end of the yield curve. Conversely, the team finds the front end of the yield curve attractive, with 2-year interest rates just above the Fed Funds Rate and aligned with the Fed’s reaction function to any deterioration in the labor market or growth. Within credit, the team believes the Return of the Red Wave can be supportive of stable credit spreads and benign default rates and, therefore, remains constructive on higher-quality corporate credit and certain parts of emerging market debt. This is despite valuations that are historically tight. Alternatively, the team is more cautious on areas that are sensitive to higher long-end yields, like commercial real estate and other consumer facing segments.

The question remains whether the new coalition 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 in 2025.

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