Outlook 2025: breaking down central bank policies and rates

Since the COVID crisis in 2020, many countries have experienced economic cycles moving in similar directions. They faced similar lockdowns, supply chain problems, fiscal easing, monetary easing, and energy crises. In 2023 and early 2024, we saw these effects continue as monetary policy tightened and inflation began to normalise.

But following four years of synchronised economic fortunes, we saw a big divergence in 2024: the continued economic strength of the US. Despite tighter policy rates, the consumers had deep enough pockets to keep spending, at least in aggregate. In many other parts of the world—including Europe—the economic prospects became weaker quite quickly in 2024.

Central banks’ reaction: calibration or recalibration?

This divergence wasn’t necessarily reflected in the reaction of the Federal Reserve. The synchronised hiking of developed market central banks turned into cutting in the latter half of 2024. Here we already see an important divergence in how central banks are positioning themselves.

The central banks that were more flexible and forward-looking in the past are doing the same now. This divergence can be phrased as those central banks that are 'recalibrating' monetary policy (Fed, SNB, BoC) and those that are 'calibrating' their policy stance (ECB, BoE).

Recalibration is understanding that underlying data has shifted and policy is no longer aligned with reaching the underlying objectives, so you adjust the policy stance clearly. Calibration is adjusting the current policy based on a slow adjustment of data towards expectations.

Powell recalibrated his message in September when the Fed cut policy rates by 50bps to start the cutting cycle, as he said in Jackson Hole that “the cooling in labour market conditions is unmistakable” and “we do not seek or welcome further cooling in labour market conditions.” This is a clear and abrupt shift from previous rhetoric and explained the need for a recalibration.

Lagarde’s ECB only cut interest rates in small increments as inflation was moving towards target, even though the European economy has been stagnating over the past year and a half and is in a much weaker position compared to the US. Using her own words: “We don’t recalibrate, we calibrate, and this is really the process through which we go,” showing a misunderstanding of the European economy and resulting in a lagging monetary policy reaction through calibration.

So, following a different approach to monetary policy easing, the Federal Reserve is now facing an even larger challenge: managing the Trump presidency.

Trump confusion

Many Trump policies have a high level of uncertainty. An important uncertainty is whether these policies will be implemented—and to what extent—as it will determine their impact on macroeconomic outcomes and interest rates.

Take, for example, immigration. Apart from the important human impact, mass deportations will clearly cause disruption, higher inflation (through a negative supply shock), and lower growth. Implementation could range from sending a few buses to the border to a multi-million deportation programme. Clearly, the difference in impact would be huge.

Similar uncertainties apply to his tariffs, trade policy, taxation, deregulation, government cost-cutting, social security, healthcare, etc. All of these have a short-term impact on inflation or a long-term impact on growth, positive or negative depending on the policy. Even a small difference in policy mix could have an entirely different growth and inflation outcome.

As many of these policies will not yet have a direct impact during Q1 or Q2 of 2025, they might influence the economy through changes in expectations. This also applies to the Federal Reserve. It will need to decide whether the policies in aggregate will have a material impact on growth and inflation. It is broadly expected that the Fed will take a cautious stance and delay some of the cuts that were expected for early 2025.

What is the most likely outcome from our perspective?

There are a few guiding principles we can consider. First, we can assume a certain level of self-preservation. The Biden administration was penalised by the electorate for sustained higher price levels, despite the normalisation of the inflation rate. The Trump team will have learned that an inflationary policy mix is undesirable.

Secondly, although we can expect many unorthodox measures, it is safe to assume that there should be an orthodoxy bias towards policies impacting growth and inflation. A weakening economy is likely to be negative for future (mid-term) elections. The nomination of Bessent as Treasury Secretary is an example of a more market-friendly choice where economic policy is impacted.

This allows us to take a more moderate view on the upside risks to inflation. Similarly, on the growth side, we expect multiple policies to be moderately pro-growth over a baseline scenario of moderating growth. This means that the higher interest rates in the US are starting to correctly reflect these changes. The market is already pricing in sufficiently higher rates after the sell-off in October and November. US 10-year yields went up from 3.85% to 4.45%. For us, this is a signal to add duration in the US.

Volatility

How do we translate this in portfolios? As active managers, we deal with this by taking positions where we can afford the market to move in the other direction initially, which is always possible in high-volatility environments.

This means three things:

01

Size the position so that you are not forced to close it early because of volatility.

02

Enter the position gradually and add to it as the market creates better entry points. Given the high-volatility framework, investors are likely to get multiple opportunities.

03

Consider less volatile proxies (e.g., other developed markets instead of US Treasuries).

For example, after reducing duration around the end of September in the US, we are now keen to add more duration again to our global portfolios as interest rates have moved up significantly during October and November. Rates are now better reflecting our medium-term view.

We have been doing this by first adding duration in other markets, like the UK and New Zealand. Not only do these markets merit higher allocation, but the correlation with US Treasuries should be positive. We see them now as excellent proxies for the US but not subject to the same policy uncertainty.

In a second step, we will gradually add again to US Treasuries, keeping enough space in the portfolio to add more in case yields move up on expected volatility.

It will remain rocky, but this seems an efficient way to express our medium-term view, where US yields have become attractive.