Government Bond Market Opportunities and the Outlook for the US Dollar

Original Release on November 14th, 2023: Our roundtable discussion on the future of the global economy and markets continues, as our analysts preview what is ahead for government bonds, currencies, housing and more.

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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 is ahead for the global economy and markets in 2024. It's Tuesday, November 14th at 10 a.m. in New York. 

Yesterday you heard from Seth Carpenter, our Global Chief Economist, and Mike Wilson, our Chief Investment Officer and the Chief U.S. Equity Strategist. Today, we will cover what is ahead for government bonds, corporate credit, currencies and housing. I am joined by Matt Hornbach, our Chief Macro Strategist, James Lord, the Global Head of Currency and Emerging Markets Strategy, Andrew Sheets, Global Head of Credit Research, and Jay Bacow, Co-Head of U.S. Securities Products.

Vishy Tirupattur: Matt, 2023 was quite a year for long end government bond yields globally. We saw dramatic curve inversion and long end yields reaching levels we had not seen in well over a decade. We've also seen both dramatic sell offs and dramatic rallies, even just in the last few weeks. Against this background, how do you see the outlook for government bond yields in 2024? 

Matt Hornbach: So we're calling our 2024 outlook for government bond markets the land of confusion. And it's because bond markets were whipped around so much by central banks in 2023 and in 2022. In the end, what central banks gave in terms of accommodative monetary policy in 2020 and 2021, they more than took away in 2022 and this past year. At least when it came to interest rate related monetary policies. 2024, of course, is going to be a pretty confusing year for investors because, as you've heard, our economists do think that rates are going to be coming down, but so too will balance sheets. 

But for the past couple of years, both G10 and EM central banks have raised rates to levels that we haven't seen in decades. Considering the possibility that equilibrium rates have trended lower over the past few decades, central bank policy rates may be actually much more restricted today than at any point since the 1970s. But, you know, we can't say the same for central bank balance sheets, even though they've been shrinking for well over a year now. They're still larger than before the pandemic. 

Now, our economists forecast continued declines in the balance sheets of the Fed, the ECB, the Bank of England and the Bank of Japan. But nevertheless, in aggregate, the balance sheet sizes of these G4 central banks will remain above their pre-pandemic levels at the end of 2024 and 2025.

Vishy Tirupattur: Matt, across the developed markets. Where do you see the best opportunity for investors in the government bond markets? 

Matt Hornbach: So Vishy we think most of the opportunities in 2024 will be in Europe given the diverging paths between eurozone countries. Germany, Austria and Portugal will benefit from supportive supply numbers, while another group, including Italy, Belgium and Ireland will likely witness a higher supply dynamic. Our call for a re widening of EGB spreads should actually last longer than we originally anticipated. 

Elsewhere in Europe, we're expecting the Bank of England to deliver 100 basis points of cumulative cuts by the end of 2024, and that compares to significantly less that's priced in by the market. Hence, our forecasts for gilts imply a much lower level of yields and a steeper yield curve than what you see implied in current forward rates. So the UK probably presents the best duration and curve opportunity set in 2024. 

Vishy Tirupattur: Thank you, Matt. James, a strong dollar driven by upside surprises to U.S. growth and higher for longer narrative that has a world during the year characterized the strong dollar view for much of the year. How do you assess 2024 to be? And what differences do you expect between developed markets and emerging market currency markets? 

James Lord: So we expect the recent strengthening of US dollar to continue for a while longer. This stronger for a longer view on the US dollar is driven by some familiar drivers to what we witnessed in 2023, but with a little bit of nuance. So first, growth. US growth, while slowing, is expected to outperform consensus expectations and remain near potential growth rates in the first half of 2024. This is going to contrast quite sharply with recessionary or near recessionary conditions in Europe and pretty uncompelling rates of growth in China. 

The second reason we see continued dollar strength is rate differentials. So when we look at our US and European rate strategy teams forecasts, they have rates moving in favor of the dollar. Final reason is defense, really. The dollar likely is going to keep outperforming other currencies around the world due to its pretty defensive characteristics in a world of continued low growth, and downside risks from very tight central bank monetary policy and geopolitical risks. The dollar not only offers liquidity and safe haven status, but also high yields, which is of course making it pretty appealing. 

We don't expect this early strength in US Dollar to last all year, though, as fiscal support for the US economy falls back and the impact of high rates takes over, US growth slows down and the Fed starts to cut around the middle of the year. And once it starts cutting, our U.S. econ team expects it to cut all the way back to 2.25 to 2.5% by the end of 2025. So a deep easing cycle. As that outlook gets increasingly priced into the US rates, market rate differentials start moving against the dollar to push the currency down. 

Vishy Tirupattur: Andrew, we are ending 2023 in a reasonably good setup for credit markets, especially at the higher quality end of the trade market. How do you expect this quality based divergence across global trade markets to play out in 2024? 

Andrew Sheets: That's right. We see a generally supportive environment for credit in 2024, aided by supportive fundamentals, supportive technicals and average valuations. Corporate credit, especially investment grade, is part of a constellation of high quality fixed income that we see putting up good returns next year, both outright and risk adjusted. 

When we talk about credit being part of this constellation of quality and looking attractive relative to other assets, it's important to appreciate the cross-asset valuations, especially relative to equities, really have moved. For most of the last 20 years the earnings yield on the S&P 500, that is the total earnings you get from the index relative to what you pay for it, has been much higher than the yield on U.S. triple B rated corporate bonds. But that's now flipped with the yield on corporate bonds now higher to one of the greatest extents we've seen outside of a crisis in 20 years. Theoretically, this higher yield on corporate bonds relative to the equity market should suggest a better relative valuation of the former. 

So what are we seeing now from companies? Well companies are buying back less stock and also issuing less debt than expected, exactly what you'd expect if companies saw the cost of their debt as high relative to where the equities are valued. 

A potential undershoot in corporate bonds supply could be met with higher bond demand. We've seen enormous year to date flows into money market funds that have absolutely dwarfed the flows into credit. But if the Fed really is done raising rates and is going to start to cut rates next year, as Morgan Stanley's economists expect, this could help push some of this money currently sitting in money market funds into bond funds, as investors look to lock in higher yields for longer. 

Against this backdrop, we think the credit valuations, for lack of a better word, are fine. With major markets in both the U.S. and Europe generally trading around their long term median and high yield looking a little bit expensive to investment grade within this. Valuations in Asia are the richest in our view, and that's especially true given the heightened economic uncertainty we see in the region. We think that credit curves offer an important way for investors to maximize the return of these kind of average spreads. And we like the 3 to 5 year part of the U.S. credit curve and the 5 to 10 year part of the investment grade curve in Europe the most. 

Vishy Tirupattur: Thanks, Andrew. Jay, 2023 was indeed a tough year for the agency in the US market, but for the US housing market it held up quite remarkably, despite the higher mortgage rates. As you look ahead to 2024, what is the outlook for US housing and the agency MBS markets and what are the key drivers of your expectations? 

Jay Bacow: Let's start off with the broader housing market before we get into the views for agency mortgages. Given our outlook for rates to rally next year, my co-head of securitized products research Jim Egan, who also runs US housing, thinks that we should expect affordability to improve and for sale inventory to increase. Both of these developments are constructive for housing activity, but the latter provides a potential counterbalance for home prices. 

Now, affordability will still be challenged, but the direction of travel matters. He expects housing activity to be stronger in the second half of '24 and for new home sales to increase more than existing home sales over the course of the full year. Home prices should see modest declines as the growth in inventory offsets the increased demand. But it's important to stress here that we believe homeowners retain strong hands in the cycle. We don't believe they will be forced sellers into materially weaker bids, and as such, we don't expect any sizable correction in prices. But we do see home prices down 3% by the end of 2024. 

Now, that pickup in housing activity means that issuance is going to pick up as well in the agency mortgage market modestly with an extra $50 billion versus where we think 2023 ends. We also think the Fed is going to be reducing their mortgage portfolio for the whole year, even as Q2 starts to taper in the fall, as the Fed allows their mortgage portfolio to run off unabated. And so the private market is going to have to digest about $510 billion mortgages next year, which is still a concerning amount but we think mortgages are priced for this. 

Vishy Tirupattur: Thanks, Jay. And thank you, Matt, James and Andrew as well. And thank you to our listeners for joining us for this 2 part roundtable discussion of our expectations for the global economy and the markets in 2024. As a reminder, if you enjoy the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.