Paul Diggle

The rate cutting cycle is getting cut short

We expect the Federal Reserve (Fed) to cut to a higher terminal rate and now see the rate cutting cycle stalling at a fed funds rate of 3.5-3.75% in the second half of 2025.

Under a second Donald Trump term we expect a combination of fiscal loosening and deregulation to modestly lift growth, albeit with most of the boost coming in 2026 when any extra tax cuts would take effect. This pickup in demand will contribute to stronger inflationary pressures.

Large tariff increases on imports as well as a sharp decline in net migration, will also put upward pressure on prices via a negative supply shock.

As a result, we think the Fed’s preferred measure of core PCE inflation will get stuck at close to 2.5% year over year through 2025 and 2026. This means the Fed will have less room to ease policy. We think it will need to keep interest rates well above neutral to keep inflation expectations anchored.

A higher-for-longer profile for US rates will affect central banks across the world. In general, the direction of travel for emerging markets (EMs) remains for lower rates, but the pace and extent of their cutting cycles might be more restrained.

Debt is a worry again

Global government debt has risen above $100 trillion, close to 100% of global GDP.  US government debt is well over 100% of GDP and the deficit is 6.7%. This is extremely large given that the economy is essentially at full employment.

Trump’s policies could increase the US debt and deficit even further and lead to higher term premia on US debt. Investors may demand more compensation for the risks of higher inflation and greater uncertainty associated with the Trump presidency.

In our base case, we see the deficit increasing to above 7% of GDP, and there are scenarios in which it climbs much more.

Moreover, we think the term premium may also increase for non-debt related reasons. More negative supply shocks, such as from climate change and geopolitics, will lead to more periods of high inflation and low growth. This may cause sustained positive correlation between bonds and equities, pushing up on the term premium and so US borrowing costs.

There can be emerging market winners as well as losers from changing patterns of globalisation

Heightened trade policy uncertainty and a more inflationary backdrop in the US will be difficult for many EMs to navigate.

Mexico’s and Vietnam’s large trade surpluses with the US put them at the greatest risk of punitive action from Washington but could emerge as the long-run winners of shifting supply chains, especially if US efforts primarily focus on decoupling from China.

We do not anticipate a breakdown of the US-Mexico trading relationship. Mexico’s deep integration with US manufacturing underpins our view that it will ultimately be spared from major trade restrictions, as was the case during Trump’s first presidency. Indeed, the more the US decouples from China, the more it will need other countries, and Mexico is well placed to capture this change.

US foreign policy will try to create the conditions for ceasefires in both Ukraine and the Middle East

We expect ongoing volatility in the Middle East and the focus of Israeli and US security policy to increasingly focus on Iran. Our base case envisages intermittent military exchanges between Israel, Iranian-backed militia groups, and Iran itself.

We also expect US policy towards Iran to return to a similar position to the one it was in under Trump’s first term (“maximum pressure”), with a greater use and enforcement of sanctions (including on oil exports) and constraining the Iranian nuclear programme.

While there is an upside scenario in which Iran responds to US pressure by ending its nuclear programme and regional tensions improve significantly, there is also a downside one in which direct Israeli-Iranian fighting escalates into a larger regional war.

Europe is the next source of political risk

The German federal elections are likely to occur in the spring and a key electoral issue is the future of the “debt brake”, which limits deficit spending to 0.35% of GDP. We think Germany’s next government will reform the debt brake in some capacity, but the contours of any changes are much less certain and depends on the eventual government’s seat count, and is likely to translate to only modest fiscal expansion.

Meanwhile, France’s political and fiscal problems are more acute following the failure of Michel Barnier to pass a budget containing the fiscal consolidation required by the European Commission’s Excessive Deficit Procedure.

Fresh parliamentary elections are only possible one year after the previous election, it is uncertain how a government can be formed in the meantime that will retain parliamentary confidence.

France’s fiscal position continues to look very challenging, and we think the country should be seen more as a peripheral market than a core one, and French spreads should trade accordingly.