Morgan Stanley releases "2025 Top 10 Surprises": US dollar depreciation ranks first.

As 2024 is coming to an end, on December 20th, the global macro team led by Morgan Stanley analysts Matthew Hornbach and Andrew M Watrous released a new research report, listing the top ten unexpected events that may occur in the global capital markets next year. Specifically, Morgan Stanley predicts that next year the fiscal deficit in the United States may not be as aggressive as expected, but instead, Germany's fiscal spending will expand, meaning that interest rates in the US and Europe will converge, leading to a significant devaluation of the US dollar. The forecast is that the US dollar index will reach a level of 101 by the end of next year, with increased downside risks. Furthermore, Morgan Stanley predicts that demand for US bonds in 2025 will be stronger than expected, mainly driven by purchases from banks, foreign investors, and pension funds, which will keep long-term US bond yields at a low level. Although the market generally holds a pessimistic view on the euro's performance, Morgan Stanley believes that with stronger-than-expected interest rate cuts, less-than-expected trade impacts, and the prospect of significant capital inflows, the euro may shine brightly. Convergence of US and European interest rates may lead to a significant devaluation of the US dollar Morgan Stanley believes that the fiscal deficit in the United States is likely to decrease next year, while Germany's fiscal deficit is expected to increase, which could lead to the convergence of US and Europe interest rates and a significant devaluation of the US dollar. The nominee for the next US Treasury Secretary, Bezent, had previously stated that reducing the deficit as a percentage of GDP to 3% is a priority. Morgan Stanley stated in the report that this commitment is generally considered difficult to achieve in the next presidential term, but there may be some progress by 2025. The report states that considering the possibility of more conservative US fiscal policies in 2025, US government bond yields are expected to fall below expected levels. Morgan Stanley predicts that the US dollar index could reach 101 by the end of 2025, with increased downside risks. For Germany, the largest economy in the Eurozone, the report believes that the upcoming elections in February will reduce policy uncertainty with the formation of a new government, which will boost economic growth and provide more space for financial expenditures. The report forecasts that Germany's economic growth in 2025 will reach 0.8%, surpassing the general expectation of 0.6%. As of the time of writing, the US dollar index is at 107.97. Strong recovery in US bond demand, long bond yields at low levels The report suggests that demand for US bonds in 2025 will be stronger than expected, mainly driven by purchases from banks, foreign investors, and pension funds. Expectations of inflation and deficit prospects under Trump's return to the White House will increase expectations for long-term US bond yields, prompting investors to sell long-term US bonds in the fourth quarter of this year. However, Morgan Stanley does not agree with this view and expects long-term US bond yields to remain at low levels next year. The report states that the downward trend in long-term US bond yields next year will not only increase buying pressure but also that structural demand may be stronger than expected, mainly from purchases by banks, foreign investors, and pension funds. Regarding banks, increased uncertainty about the Federal Reserve's policy path will lead banks to increase their holdings of US government bonds, especially with long-term US bond prospects becoming more attractive, as positive holding period returns (US bond yields > overnight index swap rates) will continue to attract demand. Foreign investors will focus on the impact of the new government's fiscal policies on negative growth, reviving expectations for interest rate cuts and boosting demand for US bonds. The report cites the example of Japanese investors who have been on the sidelines for the past year, as attractive arbitrage trades and hedge costs redirect investment returns from Japan to non-yen bonds. Regarding pension funds, the report believes that their asset surplus position (market value of assets exceeding the present value of future liabilities) will lead them to rebalance their investment portfolios and adopt a strategy of de-risking by moving from stocks to long-term government bonds, especially when long-term rates remain high and stocks continue to rise. Euro performing well The report suggests that although the market is pessimistic about the euro, low expectations mean that Europe is more likely to exceed expectations, especially in a scenario where private consumption drives growth. Trump's return to the White House has brought trade policy concerns to the global stage, putting pressure on the already challenging economic outlook in Europe. However, Morgan Stanley believes that despite general expectations being pessimistic, the European economy may surprise positively. On the one hand, Morgan Stanley believes that the fundamentals of trade policy may not be as aggressive as many investors fear, especially concerning policies related to Europe, and the euro still contains a "considerable amount" of trade-related risk premium. The report also adds that market underestimates the extent of the ECB's rate cut cycle by around 75 basis points, and one can expect that with more aggressive rate cuts, the economy still has room for growth. Better-than-expected economic growth, unexpected favorable political news domestically and abroad, and lower expectation thresholds may prompt domestic and foreign investors to reallocate capital. On the other hand, the report states that capital inflows are a particularly important potential area of surprise. For example, in the case of ten-year government bonds, the nominal yield of US treasuries is more than 200 basis points higher than that of German bonds, but once the foreign exchange hedging costs are taken into account, this yield advantage disappears. While Morgan Stanley expects yields in the US and Europe to fall, the US curve is unlikely to experience a meaningful reversal, suggesting that if Europe's situation starts to unexpectedly improve, European investors may be willing to deploy more capital in the region. The report also states that although the market generally holds a pessimistic view on the euro, the euro/dollar has been trading within a fairly narrow range, and if there is a significant unexpected change in investors' bearish sentiment, it could push the euro/dollar above the range top. The Bank of England shortens its rate cut cycle, Japanese bond yields flatten... In addition to the above three points, the report also outlines other potential events that may occur in 2025."Surprise" eventSOFR (Secured Overnight Financing Rate) basis swap curve flattens. The issuance of US Treasury securities is lower than expected, leading to an expansion of basis swap spreads. The Fed may increase purchases of short-term Treasuries to adjust the maturity structure of its balance sheet. The Bank of England shortens its easing cycle. Persistent inflation limits the Bank of England's ability to further reduce interest rates, consequently restraining the performance of the UK government bond market. Japanese government bond curve flattens. In the event of a hard landing for the US economy or slower-than-expected wage growth in Japan, the Japanese government bond yield curve may flatten, rather than steepen. Eurozone 10/30-year yield curve flattens. Although the macro backdrop supports a steeper Eurozone 10/30-year yield curve, the ECB's rate cuts and a slight repricing of volatility may pose risks to this position in the early months of 2025. The reaction of the US dollar to tariffs may be limited. The US dollar is unlikely to be significantly affected by aggressive tariff policies, but in the event of a slowdown in US economic growth or the Fed's sensitivity to developments compared to other central banks, downside risks for the dollar may emerge. US inflation expectations decrease. While the policies of the Trump administration may be perceived as inflationary, if the impact of demand destruction and tariffs outweighs the initial inflationary effects, inflation expectations may decrease. Emerging market local bonds rebound. Due to a weakening US dollar, emerging market local currency bonds may perform well, especially high-yield bonds from countries like Brazil, Mexico, Indonesia, and South Africa. This article is reproduced from "Wall Street Observer," GMTEight Editor: Jiang Yuanhua.