Matt Hornbach: A Narrative of Declining Inflation

As the data continues to show a weakness in inflation, is it enough to convince investors that the Fed may turn dovish on monetary policy? And how are these expectations impacting Treasury yields?

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Welcome to Thoughts on the Market. I'm Matthew Hornbach, Morgan Stanley's Global Head of Macro Strategy. Along with my colleagues, bringing you a variety of perspectives, today I'll talk about expectations for the Fed's monetary policy this year, and its impact on Treasury yields. It's Tuesday, January 31st at 10 a.m. in New York. 

So far, 2023 seems to be 2022 in reverse. High inflation, which defined most of last year, seems to have given way to a narrative of rapidly declining inflation. Wages, the Consumer Price index, data from the Institute of Supply Management, or ISM, and small business surveys all suggest softening. And Treasury markets have reacted with a meaningful decline in yield. 

We've now had three consecutive inflation reports, I think of them as three strikes, that did not highlight any major inflation concerns, with two of the reports being outright negative surprises. The Fed hasn't quite acknowledged the weakness in inflation, but will the third strike be enough to convince investors that inflation is slowing, so much so that the Fed may change its view on terminal rates and the path of rates thereafter? 

We think it is. With inflation likely on course to miss the Fed's December projections, the Fed may decide to make dovish changes to those projections at the March FOMC meeting. And in fact, the market is already pricing a deeper than expected rate cutting cycle, which aligns with the idea of lower than projected inflation. 

In anticipation of the March meeting, markets are pricing in nearly another 25 basis point rate hike, while our economists see a Fed that remains on hold. The driver of our economists view is that non-farm payroll gains will decelerate further, and core services ex housing inflation will soften as well, pushing the Fed to stay put with a target range between 4.5% and 4.75%.

In addition to all of this, it has become clear from our conversations with investors, and recent price action, that the markets of 2022 left fixed income investors with extra cash on the sidelines that's ready to be deployed in 2023. That extra cash is likely to depress term premiums in the U.S. Treasury market, especially in the belly -or intermediate sector- of the yield curve. 

Given these developments, we have revised lower our Treasury yield forecasts. We see the 10 year Treasury yield ending the year near 3%, and the 2 year yield ending the year near 3.25%. That would represent a fairly dramatic steepening of the Treasury yield curve in 2023. 

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