Morgan Stanley: Buy Bonds, Predicts Sharp Inflation Drop

Key Takeaway

• Morgan Stanley advises buying US government bonds, predicting inflation will decline faster than market expectations due to "residual seasonality."
• They forecast the Fed will cut its target rate by 75 basis points in 2025, more than current market predictions of just over 50 basis points.
• Despite past missteps on bond recommendations, Morgan Stanley sees a strong case for bond investment as inflation and employment cost measures are expected to show deceleration.

Treasury Rally Amid Inflation Outlook

Morgan Stanley's strategists, including Matthew Hornbach, James Lord, and Andrew Watrous, have made a compelling case for buying US government bonds, citing a potential rapid deceleration in inflation. Their analysis, taking into account "residual seasonality," suggests that core PCE inflation rates for both three- and six-month annualized periods could fall more swiftly than markets currently anticipate. This prediction is based on a statistical quirk that they believe has been overlooked, leading to an overestimation of inflation pressures earlier in the year.

The firm expects this recalibration of inflation expectations to significantly impact market dynamics, potentially leading to the Federal Reserve cutting its target rate by 75 basis points in 2025, a more aggressive easing than currently priced in by the market. This outlook is grounded in the observation that both the Bureau of Labor Statistics and the Bureau of Economic Analysis may have previously misjudged the seasonal uptick in inflation, contributing to a mispricing in the bond market.

Market Reactions and Fed Expectations

The Treasury market has recently witnessed a notable rally, with yields on two-year Treasuries dropping nearly 20 basis points to 4.8%, and 10-year yields approaching 4.5%. This movement aligns with Morgan Stanley's advice to investors to capitalize on the anticipated inflation slowdown. The market's optimism is further bolstered by Charles Schwab's Kathy Jones, who predicts two Fed rate cuts this year, despite Barclays Plc's caution against overestimating the likelihood of a July rate cut.

The rally, however, faces potential headwinds from a series of Treasury auctions totaling $125 billion, which could test the market's appetite for US debt. This comes after a volatile April, which saw the Treasury market's worst monthly performance of the year, followed by a rebound last week.

Inflation and Auction Challenges

Despite recent dovish signals from Federal Reserve Chair Jerome Powell and a cooling US labor market, the persistent issue of sticky inflation poses a significant challenge to the bond market's momentum. The upcoming Treasury auctions, particularly for longer-dated securities, will serve as a critical test of market demand amid these inflation concerns.

Investors' preference for shorter-term securities reflects a cautious stance towards the long end of the yield curve, adjusting expectations to nearly two full rate cuts this year. This cautious approach is underscored by the mixed economic data, with recent reports indicating stubborn pricing pressures in manufacturing and services, despite signs of slowing wage growth.

Street Views

• Matthew Hornbach, James Lord, and Andrew Watrous, Morgan Stanley (Bullish on US government bonds):

  "Even if the economy doesn’t go down, bond yields could still fall dramatically as inflation data disappoint the higher-forever true believers. Buy bonds."