Will the Fed’s Pivot Favor Bonds Over Equities?

Hear our perspective on market action following the Fed's change in direction, and what it means for our 2024 outlook. 

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Vishy Tirupattur: Welcome to Thoughts on the Market. I'm Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist. In this special episode I'm joined by my colleague and Global Head of Cross-Asset Strategy, Serena Tang. Along with our colleagues bringing you a variety of perspectives, we'll be talking about how our views have evolved since we published our 2024 outlook over a month ago. It's Tuesday, December 19th, at 10 a.m. in New York. 

Vishy Tirupattur: Hello, Serena. Thank you for joining me in the show. 

Serena Tang: Very happy to join you. 

Vishy Tirupattur: Since we published our 2024 outlook, we've had some big moves across markets. So how do you think our views have changed from your perch as the Head of Cross-Asset Strategy? 

Serena Tang: Markets have moved a lot and have moved very, very quickly. When we first published our outlook just a month ago, you and I both had investors push back on our macro strategy team's forecast of U.S. ten year Treasury yields at below 4%. And you know what? We are at those levels now. In a similar vein, MSCI EM, which is the broad index of emerging market equities that we track, that is at our equity strategies price target. And we are now also through our base case target for U.S. high grade corporate bonds. So I would say this has shifted our short term views. Our U.S. rate strategy team, they've recently gone tactically neutral on government bonds as the markets have repriced quickly, maybe a bit too quickly. Now, that being said, on a strategic horizon, my team and I have been arguing for a strong preference for high quality fixed income over higher beta assets going into 2024. In large part because risky assets like equities, like high yield corporate bonds, they have been pricing in a perfect landing and not paying investors enough premium for the risk that the world may be less than perfect. And the assets which have valuation cushion right now, especially after rally we've seen these past few weeks, is still high grade fixed income. You know U.S. yields are close to post global financial crisis highs, while equity risk premiums have been falling most of this past year. So, yes, markets have moved, but our strategic view of being overweight in high quality fixed income over higher beta markets have not changed. So for you Vishy, you know, when we published our year ahead outlook, we had some pushback, not just on the rates view but also on a forecast for the Fed to cut four times next year. The market is clearly moved beyond that now. What do you think has driven that rally? 

Vishy Tirupattur: Serena, the pushback we had was really about the motivation and timing of the Fed cuts. As you know, our economists are calling for cuts starting in June as the economy and inflation begin to decelerate. Some people initially pushed back on this idea, that the Fed starts cutting rates before we get to the 2% core PCE target rate. After the downward surprise in CPI last week and more so after the FOMC meeting, which came across more dovish than the markets as well as us expected, the market narrative, including the pushback we've been getting, have dramatically changed. Clearly, the markets interpreted the messaging from the FOMC statement, the dot plot and the press conference to be unequivocally dovish. The changes in the market narratives notwithstanding, we continue to expect 100 basis point cuts over 2024. I would note that in a world where inflation is falling, standard economic models would prescribe rate cuts and in 2024 inflation is projected to fall further. And because the Fed targets the level of real leads to maintain the same level of restraint, the Fed needs to cut nominal rates in line with falling inflation. This is the reasoning we see behind Fed's projection for cutting cycle to begin next year. Cutting the policy rate is not to stimulate the economy, but really to move monetary policy towards a more normalized level. While the real rate will be likely lower at the end of next year than it is today, it will still remain elevated above neutral, nevertheless. 

Serena Tang: So do you think the markets are right to go with the Fed pivot narrative at this point in time? What are the market's pricing in right now for what the Fed will do in 2024? And compared to our U.S. economist forecasts, do you see the market pricing as too bullish or bearish? 

Vishy Tirupattur: The market pricing now reflects about 140 basis points of rate cuts in 2024, and market is assigning a nearly two thirds probability of a cut materializing in March. In our view, for a march cut to be realized, we need to continue to see downward surprises in incoming inflation and growth data. To quote Chair Powell on inflation, "I'm not calling into question the progress. It's great. We just need to see more" end quote. So we don't think the Fed would be confident that enough progress has been achieved by March. So that means cuts arrive in June, if there are no further downside surprises to our inflation path. So we think market has gotten a bit ahead of itself and thus will remain tactically neutral on duration? So Serena, if the pivot is real, why are you not more bullish on equities or fixed income? Also, why are you not bullish on higher beta fixed income? 

Serena Tang: Right. As I mentioned earlier, there's a strong valuation case for fixed income over equities. The latter is pretty much priced to perfection, while the former is not. But also in an environment where the Fed pivot is real and I think you and I both believe the Fed will start easing policy next year, the rally we've seen is not entirely surprising. My team's done some work looking into past episodes of rate hikes and cuts and pauses and what it means for cross-asset performance. Now, 3 to 6 months after the last Fed hike, normally everything rallies, which makes sense. Equities rates, credit, all these markets are just very relieved there is no more policy tightening. But in 3 to 6 months going into that first Fed cut, that's when you see bonds outperform equities, investment grade bonds outperform lower quality and quality within equities outperforming as investors recognize that easing usually comes along with decelerating growth. And I think that moment of epiphany is still to come. 

Vishy Tirupattur: Thank you, Serena. Thank you for joining me. 

Vishy Tirupattur: Thank you for listening. If you enjoyed the show, please leave us a review on Apple Podcasts and share Thoughts on the Market with a friend or colleague today.