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- [00:01]
A
Welcome to Thoughts on the Market. I'm Matthew Hornbach, Global Head of Macro Strategy.
- [00:05]
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And I'm Michael Gapen, Morgan Stanley's chief U.S. economist.
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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 US dollar. It's Friday, August 29th at 10:00am in New York.
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B
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?
- [00:48]
A
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 2 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 US 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.
- [03:52]
B
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 price is the trough of any cutting cycle versus what we're thinking at any point in time?
- [04:25]
A
So once you move beyond the forecastable horizon, which you tell me about three days, probably about three days, but 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 reality reaction function of the central bank. And so to the extent that it becomes clear that this 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's pricing, the trough policy rate should also rebound. Alternatively, if the 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.
- [05:53]
B
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 US Dollar?
- [06:08]
A
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 US economy as well as inflation. So we will likely have to modify slightly the exact way in which we get down to a 4% 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, 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 our 10 year yields 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? 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.
- [08:06]
B
Quarterly path and the US dollar we.
- [08:09]
A
Have been US dollar bears since the beginning of the year and the US dollar has in fact lost about 10% of its value relative to its broad set of 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, et cetera. But in terms of the big picture, the big picture is that the dollar should continue to depreciate in our view, and that's what we'll our investors. So Mike, thanks for taking the time to talk. Great speaking with you Matt, 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. If you enjoy thoughts on the market, please leave us a review wherever you listen and share the podcast with a friend or colleague today.
- [09:18]
C
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