Is it time to sell the dollar and buy treasury bonds? Morgan Stanley: There is a high likelihood of the Fed cutting interest rates in March.

At present, the market expects the Federal Reserve to cut interest rates less than twice this year, but Morgan Stanley believes: it's too little! On January 16th, Eastern Time, Morgan Stanley economists released their latest research report, predicting that the Federal Reserve will cut interest rates by 25 basis points in March and may cut them again in June 2025. The report pointed out that the core PCE inflation data for January 2025 is expected to decrease, which will support the Federal Reserve's interest rate cut in March. Morgan Stanley also believes that US bond yields may have peaked and is optimistic about the future prospects of the US bond market. Considering the possibility of a Federal Reserve rate cut in March and the recent rise in US bond yields after the US election, Morgan Stanley believes this is a good opportunity for investors to enter the US bond market and recommends holding 5-year US Treasury bonds. Furthermore, Morgan Stanley points out that US bond yields may decline in the future, which is an important catalyst for US dollar depreciation. Therefore, Morgan Stanley suggests selling US dollars and buying euros, pounds, and yen. Reasons for the first interest rate cut in March Morgan Stanley believes that the core PCE inflation data for January, which will be released in February, will decrease, with the year-on-year growth rate expected to drop from 2.8% in December to 2.6% in January, indicating that inflation continues to approach the target level. The reasons for this are: 1. Federal Reserve officials are more optimistic about the inflation outlook. In recent days, several Federal Reserve officials have become more confident that inflation will continue to decline. Federal Reserve Governor Waller stated that inflation will continue to decline in the first quarter of 2025. New York Federal Reserve Chairman Williams said that the process of inflation decline is ongoing. Richmond Federal Reserve President Barkin believes that the latest CPI report confirms our long-standing view that inflation is declining towards the target level. 2. The data for November and December both show a continued slowdown in US inflation. In the data for November, rent and owner's equivalent rent (OER) significantly decreased. This week's released data for December CPI inflation and PPI further reinforced the signs of inflation slowdown. 3. The financial services inflation increase in January 2025 will be smaller compared to January 2024, as the first quarter of 2024 was mainly driven by strong PCE financial services data, especially the "investment management and advice" component related to past stock returns. In November and December 2023, US stock returns were particularly good, leading to a significant rise in prices in the financial services sector in January 2024. However, the monthly average returns for US stocks in November and December 2024 were 1.9%, lower than the 4.8% for the same period in 2023, so it is expected that the financial services inflation increase for January 2025 will be more moderate. Nevertheless, Morgan Stanley emphasizes that there are several factors that may affect this expectation from now until the Federal Reserve meeting in March, and investors still need to pay attention to the following risks: 1) If the US government raises tariffs early, prices may rise in the first quarter of next year as import prices will be affected by changes in tariff policies, ultimately reflected in the CPI. 2) Secondly, if the US government tightens immigration policy, it may make the Federal Reserve maintain higher interest rates for longer, as a change in immigration policy may affect the number of people seeking jobs, leading to an impact on wages and overall upward pressure on prices. 3) California wildfires may continue to push up core prices. Generally, the Federal Reserve does not pay too much attention to short-term factors affecting prices, but the destruction caused by California wildfires is significant and may have a greater impact on commodity prices than expected. However, Morgan Stanley believes that the current market prices have already taken these uncertainties into account, and even if the US government raises tariffs, it will be done gradually. In reality, the speed and intensity of expelling illegal immigrants is limited. Therefore, there is no need to worry too much about prices rising immediately; a rate cut in March is still very likely. Recommendation to increase holdings in US bonds Therefore, based on the above analysis, Morgan Stanley believes that US bond yields may have peaked and is optimistic about the prospects of US bond investments, recommending investors to increase holdings in 5-year US Treasury bonds. Additionally, Morgan Stanley points out other positive factors supporting the rise in US bond prices: On one hand, there are technical signals that are favorable for investing in bonds. Although US bond yields reached a high point last week, the Moving Average Convergence Divergence (MACD) indicator did not reach a new high, showing a significant deviation between the two data points. On the other hand, the market price already includes a considerable term premium. Morgan Stanley points out that current market conditions suggest that the lowest expected future policy rate is around 4%, a number similar to the current policy rate, and significantly higher than the mid-range value considered appropriate by Federal Reserve officials. According to Morgan Stanley, the difference of about 100 basis points between the market's lowest expected rate and the Federal Reserve officials' considered appropriate long-term rate can be seen as a term premium. Compared to the past year, this term premium is closer to its highest point rather than its lowest. When pricing government bonds, the market has already factored in the risks of economic and price uncertainty due to changes in fiscal policies, providing a higher term premium. Bearish on the US dollar Morgan Stanley believes that now is the right time to take a bearish position on the US dollar, as the US dollar index has at least tactically peaked. The reasons being: Firstly, a key driver for bearish sentiment on the US dollar is US interest rates, which have already peaked and will begin to decline. This is crucial because the direction of US fixed income has been the ultimate driver for most market dynamics, including the US dollar, since the beginning of this year. Secondly, the market has fully absorbed the positive factors that have driven the prevailing theme of investors holding large long US dollar positions. The relevant news has been fully understood and absorbed by the market, and is likely already reflected in prices. Therefore, Morgan Stanley believes that a bearish sentiment towards the US dollar is appropriate.Symmetrical risks/rewards are more likely to favor the US dollar downside rather than further US dollar strength.Thirdly, the tariff policy may disappoint investors. Currently, investors have high expectations for the tariff and fiscal expansion policies in the United States, which could pose risks to the market. Many investors expect President Trump's inauguration speech to outline a large-scale tariff plan and implement it quickly. However, the tariff policy announced by the new government in the early stages may disappoint investors in terms of scale, scope, and implementation speed. This could provide tactical opportunities for shorting the dollar, as the risk premium related to trade may be repriced. Fourthly, as the deadline for the current appropriations bill in the mid-March approaches, investors may pay more attention to fiscal policy. The negotiations at that time may reveal more details of the budget plan, particularly what will not be included in the budget. If the budget plan does not include much for fiscal expansion, its stimulative effect on the US economic growth would be limited, potentially weakening market expectations of the "American exceptionalism" and affecting the dollar trend. The report specifically mentioned that if Congress fails to pass the full-year appropriations bill by April 30th, it may trigger automatic cuts to discretionary spending later this year. Morgan Stanley analysts are closely monitoring how Congress will deal with this potential risk. Fifthly, the long positions on the dollar are overly crowded. Morgan Stanley found that currently, the market is heavily inclined towards buying the dollar, especially compared to European currencies like the euro and pound, people are more willing to hold onto the dollar. However, this increases the risk for the dollar because if something happens, many people may sell the dollar simultaneously, leading to a potential dollar index pullback. Sixthly, the dollar may face tactical selling in the short term. While the medium-term trend of the dollar ultimately depends on the US economy and policies, in the short term, some people may sell the dollar for short-term reasons, i.e. tactical selling. Moreover, it appears that the risks of the dollar weakening and US bond yields decreasing are much greater than its strengthening and yield increasing. Euro/Yen is expected to rebound In terms of investment strategy, Morgan Stanley believes that the market's expectations for the European economic outlook are overly pessimistic, indicating a higher possibility of positive surprises in European economic data. The likelihood of the European economy improving is greater than deteriorating. In this regard, inflation data and the German general election are crucial for the euro trend: Regarding inflation data: The January Eurozone CPI data to be released on February 3rd is crucial and will set the tone for Eurozone inflation trends. If inflation data exceeds expectations, it may lead to a re-evaluation of the ECB's rate cut cycle, which is positive for the euro and could strengthen it. In terms of the German general election: Investors are cautious about the outcome of the German general election. If the election results favor political and economic stability, the risks faced by the euro will be reduced, pushing the euro against the dollar higher. Morgan Stanley also points out that shorting the dollar against the yen may be preferred for the following reasons: Interest rate factor: When interest rates in the US are declining, shorting the dollar against the yen is suitable. The relationship between the dollar and the yen is closely tied to US interest rates. If US rates decrease, the dollar against the yen exchange rate is likely to decline, providing an opportunity to profit by shorting this currency pair. Expectations of a rate hike by the Bank of Japan: If the Bank of Japan raises rates in January (which is the basic expectation of Morgan Stanley economists), it will support the yen. Trump's statements may influence the trend. Historical data shows that tariff announcements usually have a negative impact on the dollar against the yen on the day of the announcement. Finally, Trump has previously expressed a desire for a stronger yen, and if he makes similar statements again, it may further boost the yen. This article is selected from "Wall Street News," written by Fang Jiayao, edited by GMTEight: Zhang Jinliang.