Is QT Ending and Will US Bond Yields Rally?

Original Release on November 22nd, 2022: The year ahead outlook is a process of collaboration between strategists and economists from across the firm, so what were analysts debating when thinking about 2023, and how were those debates resolved? Chief Cross-Asset Strategist Andrew Sheets and Head of Fixed Income Research Vishy Tirupattur discuss.

----- Transcript -----

Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Morgan Stanley's Chief Cross Asset Strategist. 

Vishy Tirupattur: And I am Vishy Tirupattur, Morgan Stanley's Head of Fixed Income Research. 

Andrew Sheets: And on this special episode of the podcast, we'll be discussing some of the key debates underpinning Morgan Stanley's 2023 year ahead outlook. It's Tuesday, November 22nd at 3 p.m. in London. 

Vishy Tirupattur: And 10 a.m. in New York. 

Andrew Sheets: So Vishy, within Morgan Stanley research we collaborate a lot, but I think it's not an exaggeration to say that when we sit down to write our year ahead outlooks for strategy and economics, it's probably one of the most collaborative exercises that we do. Part of that is some pretty intense debate. So that's what I was hoping to talk to you about, kind of give listeners some insight into what are the types of things that Morgan Stanley research analysts were debating when thinking about 2023 and how we resolved some of those issues. And I think maybe the best place to start is just this question of inflation, right? Inflation was the big surprise of 2022. We underestimated it. A lot of forecasters underestimated inflation. As we look into 2023, Morgan Stanley's economists are forecasting inflation to come down. So, how did that debate go? Why do we have conviction that this time inflation really is going to moderate? 

Vishy Tirupattur: Thanks, Andrew. And it is absolutely the case that challenging each other's view is critically important and not a surprise that we spent a lot of time on inflation. Given that we have many upside surprises to inflation throughout the year, you know, there was understandable skepticism about the forecasts that US inflation will show a steady decline over the course of 2023. Our economists, clearly, acknowledge the uncertainty associated with it, but they took some comfort in a few things. One in the base effect. Two, normalizing supply chains and weaker labor markets. They also saw that in certain goods, certain core goods, such as autos, for example, they expect to see deflation, not just disinflation. And there's also a factor of medical services, which has a reset in prices that will exert a steady drag on the core inflation. So all said and done, there is significant uncertainty, but there are still clearly some reasons why our economists expect to see inflation decline. 

Andrew Sheets: I think that's so interesting because even after we published this outlook, it's fair to say that a lot of investor skepticism has related to this idea that inflation can moderate. And another area where I think when we've been talking to investors there's some disagreement is around the growth outlook, especially for the U.S. economy. You know, we're forecasting what I would describe as a soft landing, i.e., U.S. growth slows but you do not see a U.S. recession next year. A lot of investors do expect a U.S. recession. So why did we take a different view? Why do we think the U.S. economy can kind of avoid this recessionary path? 

Vishy Tirupattur: I think the key point here is the U.S. economy slows down quite substantially. It barely skirts recession. So a 0.5% growth expectation for 2023 for the U.S. is not exactly robust growth. I think basically our economists think that the tighter monetary policy will stop tightening incrementally early in 2023, and that will play out in slowing the economy substantially without outright jumping into contraction mode. Although we all agree that there is a considerable uncertainty associated with it. 

Andrew Sheets: We've talked a bit about U.S. inflation and U.S. growth. These things have major implications for the U.S. dollar. Again, I think an area that was subject to a lot of debate was our forecast that the dollar's going to decline next year. And so, given that the U.S. is still this outperforming economy, that's avoiding a recession, given that it still offers higher interest rates, why don't we think the dollar does well in that environment? 

Vishy Tirupattur: I think the key to this out-of-consensus view on dollar is that the decline in inflation, as our economists forecast and as we just discussed, we think will limit the potential for US rates going much higher. And furthermore, given that the monetary policy is in restrictive territory, we think there is a greater chance that we will see more downside surprises in individual data points. And while this is happening, the outlook for China, right, even though it is still challenging, appears to be shifting in the positive direction. There's a decent chance that the authorities will take steps towards ending the the "zero covid" policy. This would help bring greater balance to the global economy, and that should put less upward pressure on the dollar. 

Andrew Sheets: So Vishy, another question that generated quite a bit of debate is that next year you continue to see quantitative tightening from the Fed, the balance sheet of the Federal Reserve is shrinking, it's owning fewer bonds and yet we're also forecasting U.S. bond yields to fall. So how do you square those things? How do you think it's consistent to be forecasting lower bond yields and yet less Federal Reserve support for the bond market? 

Vishy Tirupattur: Andrew, there are two important points here. The first one is that when QT ends, really, history is really not much of a guide here. You know, we really have one data point when QT ended, before rate cuts started happening. And the thinking behind our thoughts on QT is that the Fed sees these two policy tools as being independent. And stopping QT depends really on the money market conditions and the bank demand for reserves. And therefore, QT could end either before or after December 2023 when we anticipate normalization of interest rate policy to come into effect. So, the second point is that why we think that the interest rates are going to rally is really related to the expectation of significant slowing in the economic growth. Even though the U.S. economy does not go into a contraction mode, we expect a significant slowing of the U.S. economy to 0.5% GDP growth and the economy growing below potential even into 2024 as the effects of the tighter monetary policy conditions begin to play out in the real economy. So we think the rally in U.S. rates, especially in the longer end, is really a function of this. So I think we need to keep the two policy tools a bit separate as we think about this. 

Andrew Sheets: So Vishy, I wanted us to put our credit hats on and talk a little bit about our expectations for default rates. And I think here, ironically, when we've been talking to investors, there's been disagreement on both sides. So, you know, we're forecasting a default rate for the U.S. of around 4-4.5% Next year for high yield, which is about the historical average. And you get some investors who say, that expectation is too cautious and other investors who say, that's too benign. So why is 4-4.5% reasonable and why is it reasonable in the context of those, you know, investor concerns? 

Vishy Tirupattur: It's interesting, Andrew, when you expect that some some people will think that the our expectations are too tight and others think that they are too wide and we end up somewhat in the middle of the pack, I think we are getting it right. The key point here is that the the maturity walls really are pretty modest over the next two years. The fundamentals, in terms of coverage ratios, leverage ratio, cash on balance sheets, are certainly pretty decent, which will mitigate near-term default pressures. However, as the economy begins to slow down and the earnings pressures come into play, we will expect to see the market beginning to think about maturity walls in 2025 onwards. All that means is that we will see defaults rise from the extremely low levels that we are at right now to long-term average levels without spiking to the kinds of default rates we have seen in previous economic slowdowns or recessions. 

Andrew Sheets: You know, we've had this historic rise in mortgage rates and we're forecasting a really dramatic drop in housing activity. And yet we're not forecasting nearly as a dramatic drop in U.S. home prices. So Vishy, I wanted to put this question to you in two ways. First, how do we justify a much larger decrease in housing activity relative to a more modest decrease in housing prices? And then second, would you consider our housing forecast for prices bullish or bearish relative to the consensus? 

Vishy Tirupattur: So, Andrew, the first point is pretty straightforward. You know, as mortgage rates have risen in response to higher interest rates, affordability metrics have dramatically deteriorated. The consequence of this, we think, is a very significant slowing of housing activity in terms of new home sales, housing starts, housing permits, building permits and so on. The decline in those housing activity metrics would be comparable to the kind of decline we saw after the financial crisis. However, to get the prices down anywhere close to the levels we saw in the wake of the financial crisis, we need to see forced sales. Forced sales through foreclosures, etc. that we simply don't expect to see happen in the next few years because the mortgage lending standards after the financial crisis had been significantly tighter. There exists a substantial equity in many homes today. And there's also this lock-in effect, where a large number of current mortgage holders have low mortgage rates locked in. And remember, US mortgages are predominantly fixed rate mortgages. So the takeaway here is that housing activity will drop dramatically, but home prices will drop only modestly. So relative to the rest of the street, our home price forecast is less negative, but I think the key point is that we clearly distinguish between what drives home pricing activity and what drives housing activity in terms of builds and starts and sales, etc.. And that key distinction is the reason why I feel pretty confident about our housing activity forecast and home price forecast. 

Andrew Sheets: Vishy, thanks for taking the time to talk. 

Vishy Tirupattur: Always a pleasure talking to you, Andrew. 

Andrew Sheets: Happy Thanksgiving from all of us at Thoughts on the Market. We have passed yet another exciting milestone: over 1 million downloads in a single month. I wanted to say thank you for continuing to tune in and share the show with your friends and colleagues. It wouldn't be possible without you, our listeners. 

Summary

The year ahead outlook is a process of collaboration between strategists and economists from across the firm, so what were analysts debating when thinking about 2023, and how were those debates resolved? Chief Cross-Asset Strategist Andrew Sheets and Head of Fixed Income Research Vishy Tirupattur discuss.