In the second of a two-part episode, our Chief U.S. Economist
Michael Gapen and Global Head of Macro Strategy Matthew Hornbach
talk about how Treasury yields and the U.S. dollar could react to
the possible Fed rate path.
Read more insights from Morgan Stanley.
----- Transcript -----
Matthew Hornbach: Welcome to Thoughts on
the Market. I'm Matthew Hornbach, Global Head of Macro
Strategy.
Michael Gapen: And I'm Michael Gapen Morgan
Stanley's Chief U.S. Economist.
Yesterday we talked about Michael's reaction to the Jackson Hole
meeting last week, and our assessment of the Fed's potential
policy pivot. Today my reaction to the price action that followed
Chair Powell's speech and what it means for our outlook for the
interest rate markets and the U.S. dollar.
It's Friday, August 29th at 10am in New York,
Michael Gapen: Okay, Matt. Yesterday you
were in the driver's seat asking me questions about how Chair
Powell's comments at Jackson Hole influenced our views around the
outlook for monetary policy. I'd like to turn it back to you, if
I may. What did you make of the price action that followed the
meeting?
Matthew Hornbach: Well, I think it's safe
to say that a lot of investors were surprised just as you were by
what Chair Powell delivered in his opening remarks. We saw a
fairly dramatic decline in short-term interest rates, taking the
two-year Treasury yield down quite a bit. And at the same time,
we also saw the yield curve steepen, which means that the
two-year yield fell much more than the 10-year yield and the
30-year bond yield fell. And I think what investors were thinking
with this surprise in mind is just what you mentioned earlier –
that perhaps this is a Fed that does have slightly more tolerance
for above target inflation.
And so, you can imagine a world in which, if the Fed does in fact
cut rates, as you're forecasting, or more aggressively than
you're forecasting, amidst an environment where inflation
continues to run above target. Then you could see that investors
would gravitate towards shorter maturity treasuries because the
Fed is cutting interest rates and typically shorter-term Treasury
yields follow the Fed funds rate up or down. But at the same time
reconsider their love of duration and taking duration risk.
Because when you move out the yield curve in your investments and
you're buying a 10-year bond or a 30-year bond, you are
inherently taking the view that the Fed does care about inflation
and keeping it low and moving it back to target.
And if this Fed still cares about that, but perhaps on the margin
slightly less than it did before, then perhaps investors might
demand more compensation for owning that duration risk in the
long end of the yield curve. Which would then make it more
difficult for those long-term yields to fall. And so, I think
what we saw on Friday was a pretty classic response to a Federal
Reserve speech in this case from the Chair that was much more
dovish than investors had anticipated going in.
The final thing I'd say in this regard is the following Monday,
when we looked at the market price action, there wasn't very much
follow through. In other words, the Treasury market didn't
continue to rally, yields didn't continue to fall. And I think
what that is telling you is that investors are still relatively
optimistic about the economy at this point. Investors aren't
worried that the Fed knows something that they don't. And so, as
a result, we didn't really see much follow through in the U.S.
Treasury market on the following Monday.
So, I do think that investors are going to be watching the data
much like yourself, and the Fed. And if we do end up getting
worse data, the Treasury market will likely continue to perform
very well. If the data rebounds, as you suggested in one of your
alternative scenarios, then perhaps the Treasury rally that we've
seen year-to-date will take a pause.
Michael Gapen: And if I can follow up and
ask you about your views on the trough of any cutting cycle. We
have generally been projecting an end to the easing cycle that's
below where markets are pricing. So, in general, a deeper cutting
cycle. Could some of that – the market viewpoint of greater
tolerance for inflation be driving market prices vis-a-vis what
we're thinking? Or how do you assess where the market prices, the
trough of any cutting cycle, versus what we're thinking at any
point in time?
Matthew Hornbach: So, once you move beyond
the forecastable horizon, which you tell me…
Michael Gapen: About three days …
Matthew Hornbach: Probably about three
days. But, you know, within the next couple of months, let's say.
The way that the market would price a central bank's likely
policy path, or average policy path, is going to depend on how
investors are thinking about the reaction function of the central
bank.
And so, to the extent that it becomes clear that the central
bank, the Fed, is increasingly tolerant of above target inflation
in order to ensure that the balance of risks don't become
unbalanced, let's say. Then I think you would expect to see that
show up in a lower market price for the policy rate at which the
Fed eventually stops the easing cycle, which would presumably be
lower than what investors might have been thinking earlier.
As we kind of make our way from here, closer to that trough
policy rate, of course, the data will be in the driver's seat.
So, if we saw a scenario in which the economic activity data
rebounded, then I would say that the way that the market is
pricing the trough policy rate should also rebound.
Alternatively, if we are trending towards a much weaker labor
market, then of course the market would continue to price lower
and lower trough policy rates.
Michael Gapen: So, Matt, with our new
baseline path for Fed policy with quarterly rate cuts starting in
September through the end of 2026, how has your view changed on
the likely direction and path for Treasury yields and the U.S.
dollar?
Matthew Hornbach: So, when we put together
our quarterly projections for Treasury yields, of course we link
them very closely with your forecast for Fed policy, activity in
the U.S. economy, as well as inflation.
So, we will likely have to modify slightly the exact way in which
we get down to a 4 percent 10-year yield by the end of this year,
which is our current forecast, and very likely to remain our
forecast going forward. I don't see a need at this point to
adjust our year-end forecast for 10-year Treasury yields. When we
move into 2026, again here we would also likely make some tweaks
to our quarterly path for 10-year Treasury yields.
But at this point, I'm not inclined to change the year end target
for 2026. Of course, the end of 2026 is a lifetime away it seems
from the current moment, given that we're going to have so much
to do and deal with in 2026. For example, we're going to have a
midterm election towards the end of the year, we will have a new
chair of the Federal Reserve, and there's going to be a lot for
us to deal with.
So, in thinking about where are 10-year yield is going to end
2026, it's not just about the path of the Fed funds rate between
now and then. It's also the events that occur, that are much more
difficult to forecast than let's say the 10-year Treasury yield
itself is – which is also very difficult to forecast.
But it's also about by the time we get to the end of 2026, what
are investors going to be thinking about 2027? You know, that is
really the trick to forecasting. So, at this point, we're not
inclined to change the levels to which we think Treasury yields
will get to. But we are inclined to tweak the exact quarterly
path.
Michael Gapen: And the U.S. dollar?
Matthew Hornbach: , We have been U.S.
Dollar bears since the beginning of the year, and the U.S. dollar
has in fact lost about 10 percent of its value relative to its
broad set of trading partners.
We do think that the dollar will continue to lose value over the
course of the next 12 to 18 months.
The exact quarterly path, we may have to tweak somewhat because
also the dollar is not just about the Fed path. It's also about
the path for the ECB, and the path for the Bank of England, and
the path for the Bank of Japan, etcetera. But in terms of
the big picture? The big picture is that the dollar should de
continue to depreciate in our view. And that's what we'll be
telling our investors.
So, Mike, thanks for taking the time to talk.
Michael Gapen: Great speaking with you,
Matt.
Matthew Hornbach: And thanks for listening.
We look forward to bringing you another episode around the time
of the September FOMC meeting where we will update our views once
again.
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