Must Read Research
Also featuring commentary from Global Economic Weekly
January 19, 2025
Candace Browning, Head of BofA Global Research
The engines of economic growth are revving up. This week, we explore why the outlook for Fed rate cuts has stalled as defense spending looks primed to accelerate and small businesses are shifting into higher gear.
Our U.S. Economics team thinks the Fed is done cutting rates this year as sticky inflation and a resilient labor market limit the need for additional easing.
As a result, our Rates Strategists raised their 2025 U.S. 10-year Treasury yield forecast 50bps (basis points) to 4.75%. Head of U.S. Rates Strategy Mark Cabana favors buying Treasuries after the recent rise in rates, especially if the 10-year reaches post-Covid highs near 5%. In his view, the market will struggle to price 10-year Treasuries much above 5.25%, even if markets start expecting Fed hikes. Globally, our strategists raised their European rates forecasts to account for higher U.S. yields but their expectations for late 2026 are unchanged and remain well below what markets imply. Credit Strategy also weighed in on the Fed call—they expect loans to outperform bonds in this backdrop, with 6.5% returns in 2025 despite higher default rates in the 3.5-4.5% range.
Despite growing calls for reduced government spending, Senior U.S. Aerospace & Defense analyst Ron Epstein maintains his contrarian view that defense budgets will rise.
Defense spending in fiscal year 20-24 is just 12-13% above pre-Covid levels, compared to a 45% increase in total government outlays. Ron projects 10% annual growth in defense modernization spending, driven in part by great power competition with China and Russia. European defense budgets are also rising, with 22 nations hitting the 2% of GDP (Gross Domestic Product) threshold in 2024, up from 10 in 2023.
Small businesses employ nearly 50% of American workers, so the health and forward outlooks of these companies is critical for the U.S. economy.
According to the Bank of America Institute, we’re seeing improvement on both counts. Profitability for this segment in Q424 was the highest in two years, nearly matching 2019 levels. Payrolls grew year over year across revenue tiers and the fastest growth, 5.7%, was seen in small businesses with >$1 million in annual revenues. Services-oriented businesses generally saw a slowdown in 2024 payroll growth as a “catch-up” in hiring made for a difficult 2023 comparison. That said, finance, retail, and manufacturing all saw faster growth in 2024 than in 2023. Outside surveys of small businesses also paint a constructive picture. For example, the NFIB (National Federation of Independent Business) Q424 survey suggests about one-third of respondents believe it’s a good time to expand and fewer report that credit is harder to get relative to last year.
Get multiple perspectives on the year ahead. See what unfolds in 2025 as BofA Global Research analysts share their insights on the themes that could shape the year, highlighting key trends to help you make more informed decisions.
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Claudio Irigoyen, Head of Global Economics, BofA Global Research
Why should the Fed remain on hold?
Because you shouldn't fix what is not broken. The strength of the U.S. economy builds on cyclical and structural factors. On the cyclical side, consumption remains remarkably resilient, driven by solid real income growth and healthy private sector balance sheets, coupled with fiscal policy boosting investment. On the structural side, we have observed stronger than expected productivity gains, which could be boosting potential growth of the economy by as much as half a percentage point to circa 2.3%.
We expect the economy to grow around potential this year and inflation to remain high in the 2.5%-3% range. This economy is in line with a natural interest rate (aka r*) close to 2% in real terms. The natural interest rate is by definition the level of interest rate consistent with full employment and inflation at target. The cyclical and structural dynamics displayed by the U.S. economy are therefore consistent with a natural rate pretty close to the current, but inflation is still stubbornly sticky above target.
That alone justifies the end of the easing cycle, we think. In addition, there is significant uncertainty about the impact of Trumponomics 2.0 both in the U.S. and the rest of the world. When uncertainty increases, the option value of waiting increases accordingly. Protectionist policies will not per se increase inflation on a permanent basis, but they can have an impact on inflation expectations. Even more concerning from the inflation perspective would be the impact of excessive fiscal stimulus for an economy running at potential. It might be too early to discuss hikes, but also too risky to validate cuts.
