Original Release Date November 19, 2024: On the second part
of a two-part roundtable, our panel gives its 2025 preview for
the housing and mortgage landscape, the US Treasury yield curve
and currency markets.
----- Transcript -----
Andrew Sheets: 2024 was a year of transition for
economies and global markets. Central banks began easing interest
rates, U.S. elections signaled significant policy change, and
Generative AI made a quantum leap in adoption and development.
Thank you for listening throughout 2024, as we navigated the
issues and events that shaped financial markets, and society. We
hope you'll join us next year as we continue to bring you the
most up to date information on the financial world. This week,
please enjoy some encores of episodes over the last few months
and we'll be back with all new episodes in January. From all of
us on Thoughts on the Market, Happy Holidays, and a very Happy
New Year.
Vishy Tirupattur: Welcome to Thoughts on
the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed
Income Strategist. This is part two of our special roundtable
discussion on what's ahead for the global economy and markets in
2025.
Today we will cover what is ahead for government bonds,
currencies, and housing. I'm joined by Matt Hornbach, our Chief
Macro Strategist; James Lord, Global Head of Currency and
Emerging Market Strategy; Jay Bacow, our co-head of Securitized
Product Strategy; and Jim Egan, the other co-head of Securitized
Product Strategy.
It's Tuesday, November 19th, at 10am in New York.
Matt, I'd like to go to you first. 2024 was a fascinating year
for government bond yields globally. We started with a deeply
inverted US yield curve at the beginning of the year, and we are
ending the year with a much steeper curve – with much of that
inversion gone. We have seen both meaningful sell offs and
rallies over the course of the year as markets negotiated hard
landing, soft landing, and no landing scenarios.
With the election behind us and a significant change of policy
ahead of us, how do you see the outlook for global government
bond yields in 2025?
Matt Hornbach: With the US election outcome
known, global rate markets can march to the beat of its
consequences. Central banks around the world continue to lower
policy rates in our economist baseline projection, with much
lower policy rates taking hold in their hard landing scenario
versus higher rates in their scenarios for re-acceleration.
This skew towards more dovish outcomes alongside the baseline for
lower policy rates than captured in current market prices
ultimately leads to lower government bond yields and steeper
yield curves across most of the G10 through next year.
Summarizing the regions, we expect treasury yields to move lower
over the forecast horizon, helped by 75 [basis points] worth of
Fed rate cuts, more than markets currently price.
We forecast 10-year Treasury yields reaching 3 and 3.75 per cent
by the middle of next year and ending the year just above 3.5 per
cent.
Our economists are forecasting a pause in the easing cycle in the
second half of the year from the Fed. That would leave the Fed
funds rate still above the median longer run dot.
The rationale for the pause involves Fed uncertainty over the
ultimate effects of tariffs and immigration reform on growth and
inflation.
We also see the treasury curve bull steepening throughout the
forecast horizon with most of the steepening in the first half of
the year, when most of the fall in yields occur.
Finally, on break even inflation rates, we see five- and 10-year
break evens tightening slightly by the middle of 2025 as
inflation risks cool. However, as the Trump administration starts
implementing tariffs, break evens widen in our forecast with the
five- and 10-year maturities reaching 2.55 per cent and 2.4 per
cent respectively by the end of next year.
As such, we think real yields will lead the bulk of the decline
in nominal yields in our forecasting with the 10-year real yield
around 1.45 per cent by the middle of next year; and ending the
year at 1.15 per cent.
Vishy Tirupattur: That's very helpful,
Matt. James, clearly the incoming administration has policy
choices, and their sequencing and severity will have major
implications for the strength of the dollar that has rallied
substantially in the last few months. Against this backdrop, how
do you assess 2025 to be? What differences do you expect to see
between DM and EM currency markets?
James Lord: The incoming administration's
proposed policies could have far-reaching impacts on currency
markets, some of which are already being reflected in the price
of the dollar today. We had argued ahead of the election that a
Republican sweep was probably the most bullish dollar outcome,
and we are now seeing that being reflected.
We do think the dollar rally continues for a little bit longer as
markets price in a higher likelihood of tariffs being implemented
against trading partners and there being a risk of additional
deficit expansion in 2025. However, we don't really see that
dollar strength persisting for long throughout 2025.
So, I think that is – compared to the current debate, compared to
the current market pricing – a negative dollar catalyst that
should get priced into markets.
And to your question, Vishy, that there will be differences with
EM and also within EM as well. Probably the most notable one is
the renminbi. We have the renminbi as the weakest currency within
all of our forecasts for 2025, really reflecting the impact of
tariffs.
We expect tariffs against China to be more consequential than
against other countries, thus requiring a bigger adjustment on
the FX side. We see dollar China, or dollar renminbi ending next
year at 7.6. So that represents a very sharp divergence versus
dollar yen and the broader DXY moves – and is a consequence of
tariffs.
And that does imply that the Fed's broad dollar index only has a
pretty modest decline next year, despite the bigger move in the
DXY. The rest of Asia will likely follow dollar China more
closely than dollar yen, in our view, causing AXJ currencies to
generally underperform; versus CMEA and Latin America, which on
the whole do a bit better.
Vishy Tirupattur: Jay, in contrast to
corporate credit, mortgage spreads are at or about their
long-term average levels. How do you expect 2025 to pan out for
mortgages? What are the key drivers of your expectations, and
which potential policy changes you are most focused on?
Jay Bacow: As you point out, mortgage
spreads do look wide to corporate spreads, but there are good
reasons for that. We all know that the Fed is reducing their
holdings of mortgages, and they're the largest holder of
mortgages in the world.
We don't expect Fed balance sheet reduction of mortgages to
change, even if they do NQT, as is our forecast in the first
quarter of 2025. When they NQT, we expect mortgage runoff to
continue to go into treasuries. What we do expect to change next
year is that bank demand function will shift. We are working
under the assumption that the Basel III endgame either stalls
under the next administration or gets released in a way that is
capital neutral. And that's going to free up excess capital for
banks and reduce regulatory uncertainty for them in how they
deploy the cash in their portfolios.
The one thing that we've been waiting for is this clarity around
regulations. When that changes, we think that's going to be a
positive, but it's not just banks returning to the market.
We think that there's going to be tailwinds from overseas
investors that are going to be hedging out their FX risks as the
Fed cuts rates, and the Bank of Japan hikes, so we expect more
demand from Japanese life insurance companies.
A steeper yield curve is going to be good for REIT demand. And
these buyers, banks, overseas REITs, they typically buy CUSIPs,
and that's going to help not just from a demand side, but it's
going to help funding on mortgages improve as well. And all of
those things are going to take mortgage spreads tighter, and
that's why we are bullish.
I also want to mention agency CMBS for a moment. The technical
pressure there is even better than in single family mortgages.
The supply story is still constrained, but there is no Fed QT in
multifamily. And then also the capital that's going to be
available for banks from the deregulation will allow them – in
combination with the portfolio layer hedging – to add agency CMBS
in a way that they haven't really been adding in the last few
years. So that could take spreads tighter as well.
Now, Vishy, you also mentioned policy changes. We think
discussions around GSE reform are likely to become more prevalent
under the new administration.
And we think that given that improved capitalization, depending
on the path of their earnings and any plans to raise capital, we
could see an attempt to exit conservatorship during this
administration.
But we will simply state our view that any plan that results in a
meaningful change to the capital treatment – or credit risk – to
the investors of conventional mortgages is going to be too
destabilizing for the housing finance markets to implement. And
so, we don't think that path could go forward.
Vishy Tirupattur: Thanks, Jay. Jim, it was
a challenging year for the housing market with historically high
levels of unaffordability and continued headwinds of limited
supply. How do you see 2025 to be for the US housing market? And
going beyond housing, what is your outlook for the opportunity
set in securitized credit for 2025?
James Egan: For the housing market, the
2025 narrative is going to be one about absolute level versus the
direction and rate of change. For instance, Vishy, you mentioned
affordability. Mortgage rates have increased significantly since
the beginning of September, but it's also true that they're down
roughly a hundred basis points from the fourth quarter of 2023
and we're forecasting pretty healthy decreases in the 10-year
Treasury throughout 2025. So, we expect affordability to improve
over the coming year. Supply? It remains near historic lows, but
it's been increasing year to date.
So similar to the affordability narrative, it's more challenged
than it's been in decades; but it's also less challenged than it
was a year ago.
So, what does all this mean for the housing market as we look
through 2025? Despite the improvements in affordability, sales
volumes have been pretty stagnant this year. Total volumes – so
existing plus new volumes – are actually down about 3 per cent
year to date. And look, that isn't unusual. It typically takes
about a year for sales volumes to pick up when you see this kind
of significant affordability improvement that we've witnessed
over the past year, even with the recent backup in mortgage
rates.
And that means we think we're kind of entering that sweet spot
for increased sales now. We've seen purchase applications turn
positive year over year. We've seen pending home sales turn
positive year over year. That's the first time both of those
things have happened since 2021. But when we think about how much
sales 2025, we think it's going to be a little bit more
curtailed. There are a whole host of reasons for that – but one
of them the lock in effect has been a very popular talking point
in the housing market this year. If we look at just the
difference between the effective mortgage rate on the outstanding
universe and where you can take out a mortgage rate today, the
universe is still over 200 basis points out of the money.
To the upside, you're not going to get 10 per cent growth there,
but you're going to get more than 5 per cent growth in new home
sales. And what I really want to emphasize here is – yes,
mortgage rates have increased recently. We expect them to come
down in 2025; but even if they don't, we don't think there's a
lot of room for downside to existing home sales from here.
There's some level of housing activity that has to happen,
regardless of where mortgage rates or affordability are. We think
we're there. Turnover measured as the number of transactions –
existing transactions – as a share of the outstanding housing
market is lower now than it was during the great financial
crisis. It's as low as it's been in a little bit over 40 years.
We just don't think it can fall that much further from here.
But as we go through 2025, we do think it dips negative. We have
a negative 2 per cent HPA call next year, not significantly down.
We don't think there's a lot of room to the downside given the
healthy foundation, the low supply, the strong credit standards
in the housing market. But there is a little bit of negativity
next year before home prices reaccelerate.
This leaves us generically constructive on securitized products
across the board. Given how much of the capital structure has
flattened this year, we think CLO AAAs actually offer the best
value amongst the debt tranches there. We think non-QM triple
AAAs and agency MBS is going to tighten. They look cheap to IG
corporates. Consumer ABS, we also think still looks pretty cheap
to IG corporates. Even in the CMBS pace, we think there's
opportunities. CMBS has really outperformed this year as rates
have come down. Now our bull bear spread differentials are much
wider in CMBS than they are elsewhere, but in our base case,
conduit BBB minuses still offer attractive value.
That being said, if we're going to go down the capital structure,
our favorite expression in the securitized credit space is US CLO
equity.
Vishy Tirupattur: Thank you, Jay and Jim,
and also Matt and James.
We'll close it out here. As a reminder, if you enjoyed the show,
please leave us a review wherever you listen and share Thoughts
on the Market with a friend or colleague today.
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