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Over the past month, US Treasury (UST) yields have climbed sharply as markets repriced expectations for US growth and inflation and the US Federal Reserve’s likely reaction. Case in point, the 10-year UST yield rose over 60 bps from 6 December, with 20bps in the first seven trading days of January. With disinflation in the US stalling and growth lingering at or above trend, the US Fed has sent out hawkish signals, and market expectations are now pricing in a little over one rate cut this year. UST yields currently account for around four-fifths of Asia Investment Grade (IG) credit’s all-in yields, and it would therefore not be surprising if investors are concerned about the returns prospect of Asia IG, especially with spreads now near 10-year lows.
Although the recent rise in yields has been quick and the outlook for US policy rates is also less dovish than before, we would interpret these as finite adjustments to recent economic and political developments. We continue to expect UST yields to gradually decline over the year and therefore continue to see the Asia IG segment as offering attractive yields into which investors should redeploy cash.
US growth and inflation still likely to slow this year. US economic data has been unexpectedly resilient and inflation has been looking sticky on the downside. We believe that the US Fed is likely to cut policy rates by 50bps this year and that market consensus will converge toward this. However, we also believe that the resultant policy rate of 4.00%/4.25% will still be contractionary and that it will impede both real growth and inflation.
Policy uncertainty from the incoming Trump administration muddies the outlook, but we believe the net impact might be greater on growth (slowing) than inflation (accelerating). Historically, tariffs have been decidedly negative for growth but somewhat mixed on inflation. There might be some short-term inflationary impact, but the magnitude depends a lot on exchange rate moves, retaliation from trading partners, substitution effects, and rerouting of goods. The Fed's analysis of the 2018 tariff impact concluded that the potential negative growth impact is likely to be the greater concern versus the inflationary impact.
A shift in expectations toward slower nominal US growth rates should tend to weigh on UST yields. We therefore continue to see high grade and investment grade bonds as attractive, with a preference for the five-year tenor. We see 10-year UST yields falling to around 4% by the middle of the year and remaining thereabouts through 2H2025.
Asia IG yields remain attractive above 5%. With the overall Asia IG yield around 5.5%, we maintain our Most Preferred view and recommend investors take this opportunity to reallocate from cash to Asia IG. Within Asia IG bonds, we also favor the five-year tenor, as this should directly benefit from Fed rate cuts and be less sensitive to volatility from US policy uncertainty. Even though spreads remain near 10-year lows, we see limited risk of these widening, as robust credit fundamentals and a strong technical backdrop should keep spreads capped in 1H25. Assuming UST yields do not rise substantially, Asia IG is likely to provide investors with more resilient portfolio returns.
Asia FX not likely to see significant weakness. One ancillary factor is the resilience that Asian currencies are likely to show—many of the Asia IG issuers have the bulk of their revenues in local currencies and therefore have to handle the FX risk from USD liabilities. Within the Asia IG space (JACI China accounts for 37%, while Korea, Indonesia and Hong Kong account for a total of another 43%), we expect the currencies of these three to experience limited downside against the USD over the year.
Asian currencies have already fallen by 3% on average since November in anticipation of tariff risks; those concerns have left the USD near peak levels. We remain most cautious on the CNY on account of China being the main target of tariffs; we maintain our target of 7.5 against the USD by the end of 2025. We expect the rest of the Asia FX complex to end the year roughly flat against the USD on average on the back of continued US Fed easing, and intervention by Asian central banks to avoid being accused of weakening their currencies to boost exports.
