Four fixed income predictions poised to shape 2025

2025 – the year of duration?

Over the past several years, we’ve witnessed a paradigm shift in the interest rate environment. This is not a new observation—in fact, I discussed investors’ shifting rate expectations back in November 2023. But as we enter 2025, it has created some surprising bond market dynamics, especially with regard to duration.

For at least two years, flows into short-term fixed income grew as interest rates increased and returns became more and more attractive. The industry’s consensus was that once rates started to decline—and especially after 100 or more basis points (bps) of cuts had started to make their way through the economy—we’d see investors move out along the yield curve and buy longer-dated bonds.

The rate cuts materialized. But the duration trade did not. In fact, aside from some positioning adjustments at the margins, that short-end money has been extremely sticky. In hindsight, it makes some sense: yields in the 3-4% range are much better than the 1-2% investors had expected over the previous decade and still meet the income needs of many clients, even if they aren’t as enticing as the 5%-plus yields of one year ago. Now, the question remains: when will investors pull the trigger on duration? That’s just one of the major stories that could define fixed income markets in 2025.

How did we do last year?

Before looking ahead, it’s worth looking back at some of our calls for 2024 and how they played out. Three in particular come to mind:

1. Duration: Our call at the start of 2024 was to move up the yield curve only once interest rates began to fall, and that until then, there was still value to be found in short-term bonds. As mentioned, we (and the investment community at large) were surprised that investors didn’t add as much duration as expected once the easing cycle began. But nonetheless, this turned out to be a good call: we continued to see strong performance on the short end of the curve, with the BMO Ultra Short-Term Bond ETF Fund outperforming the BMO Aggregate Bond ETF Fund in 2024.¹
2. Rate cut timing: Heading into 2024, market consensus was that the Bank of Canada (BoC) and U.S. Federal Reserve (Fed) would begin to cut interest rates early in the year, and that the Fed would cut as may as six times before year-end. We believed that the U.S. would lag Canada when it came to rate cuts, and we were 100% correct: the BoC started to ease rates in June while the Fed started cutting in September, both in line with our expectations.
3. Rate cut magnitude: We correctly believed that the market was being too optimistic about the interest rate trajectory early in the year, and that a higher-for-longer environment was likely. We were somewhat surprised, however, by the magnitude of those cuts once they materialized. In particular, the 175 basis points (bps) of easing we saw from the BoC in 2024 was more aggressive than the 75-to-100 bps of cuts we’d expected at the beginning of the year.

Our top fixed income calls for 2025

1. The duration trade will finally materialize
   We think that duration is poised to perform well in 2025, and that this year is when investors will finally move up the curve. As interest rates continue to fall, we’ve begun to see some normalization of the yield curve after a prolonged period of inversion. If the Canadian overnight rate reaches 2.0-2.5%, which is our expectation, then that would likely cause further steepening—in which case, you’ll want duration in your portfolios. It’s possible, however, that mid- and long-term rates don’t come down as much as hoped. To hedge against that possibility, our preference is for aggregate exposures like the BMO Corporate Bond ETF Fund and the BMO Aggregate Bond ETF Fund.
2. Fed and BoC policy will continue to diverge
   For years, the Fed and BoC have largely moved in lockstep. That began to change in 2024, with the BoC—driven by a weaker Canadian economy—moving to cut rates more aggressively than its American counterpart. We think that trend continues in 2025. Given the strength of the U.S. economy, the Fed is in no hurry to cut rates. Canada’s sluggish growth means that the BoC doesn’t have the same flexibility, especially given the prospect of new tariffs on Canadian goods under the Trump administration. If this divergence between U.S. and Canadian rates continues as we expect, it could lead to further depreciation of the Canadian dollar (CAD) in the near term. For this reason, Advisors and clients may wish to consider unhedged exposures for their U.S. fixed income sleeve.
3. Volatility will rise
   Our expectation is that there will be a significant uptick in market volatility in 2025. The Trump presidency creates several unknowns, including the potential for a trade war. That risk is compounded by political uncertainty in Canada given Prime Minister Justin Trudeau’s forthcoming resignation and the likelihood of a spring election. The diverging policies of the Fed and BoC, the differing economic situations in the U.S. and Canada, and the potential weakness of the CAD are among the other factors that could make 2025 something of a roller coaster for both equity and fixed income markets.
4. Canadian corporate bonds will outperform federals
   Within the Canadian fixed income universe, we think corporate bonds are best positioned to outperform in 2025. It’s likely that the continuing loosening of monetary policy will help the corporate space, even with Canada’s strained economic backdrop. The corporate bond issuers have been quite resilient, and attractive corporate spreads could also help investors weather volatility. The BMO Corporate Bond ETF Fund is well-positioned to benefit from these tailwinds, providing exposure to a diversified portfolio of Canadian corporate bonds. Beyond corporates, we also like provincial bonds, while we prefer federal bonds the least of the three—though we do expect credit to do well across the board in 2025.

*Management Expense Ratio (MER) is as of September 30, 2024.

BMO Global Asset Management, as of December 31, 2024.

Please contact your BMO Global Asset Management wholesaler for any additional support and guidance.

¹ The BMO Ultra Short-Term ETF Fund had a calendar year return of 5.2% in 2024, compared to 3.8% for the BMO Aggregate Bond ETF Fund. Source: BMO Global Asset Management.

² All investments involve risk. The value of a Mutual Fund can go down as well as up and you could lose money. The risk of a Mutual Fund is rated based on the volatility of the Mutual Fund’s returns using the standardized risk classification methodology mandated by the Canadian Securities Administrators. Historical volatility doesn’t tell you how volatile a Mutual Fund will be in the future. A Mutual Fund with a risk rating of “low” can still lose money. For more information about the risk rating and specific risks that can affect a Mutual Fund’s returns, see the BMO Mutual Fund’s simplified prospectus.