The Fed is nearing the window of interest rate cut. Will U.S. bonds and the U.S. dollar face a crucial turning point in the second half of the year?

Since the beginning of this year, global asset prices have been going through a significant adjustment: the yield on 10-year US Treasury bonds has dropped by over 50 basis points from its peak earlier this year, and the US Dollar Index (DXY) has fallen by over 10%. However, in the summer market, the downward trends of these two major assets have both encountered resistance. In its latest global macro strategy report "At the Edge of Hot Summer, At the Threshold of a Larger Fall", Morgan Stanley points out that as the window for a Fed rate cut approaches, both US bond yields and the US Dollar Index are expected to hit new lows for the year in the fall, providing investors with a clear direction for positioning. 1. Macro Theme: Fed Rate Cut as Core Drive, US Bond Yields May Fall Below 4% The Fed's policy shift is the core logic for the pricing of global assets in the second half of the year. During the annual Jackson Hole Central Bank Symposium this year, Fed Chairman Powell sent a clear dovish signal, stating that "current policy is in a restrictive zone, and the economic outlook and risk balance may require an adjustment in policy stance," directly pushing the market-implied Federal Funds Rate to fall below 3% (currently at 2.94%). Morgan Stanley points out that there is further room for this rate to decrease: on one hand, the current level is higher than 2.87% in April 2025 and 2.69% in September 2024; on the other hand, Fed economists expect the final Federal Funds Rate to drop to 2.625% (rather than the market's current pricing of 3%), mainly due to tightening US immigration policies slowing down labor market growth and consequently reducing potential economic growth and the neutral interest rate (r*). The interconnection between US bond yields and the Federal Funds Rate will continue to dominate the bond market trends. Data from the report shows that after a brief deviation in April 2025, the two have realigned. If the Fed Funds Rate falls below 2.69%, the 10-year US bond yield is expected to drop below 4%. Furthermore, improved expectations for the US fiscal deficit will also provide support for US bonds. The latest forecast from the Congressional Budget Office (CBO) shows that tariff adjustments from 2025-2035 will reduce the federal deficit by $4 trillion (higher than the $3 trillion forecast in June), reducing the need for new debt issuances and further suppressing long-term yields. 2. Core Investment Strategy: Long Duration US Bonds, Short US Dollar, Seize Opportunities in Two Major Themes Based on the above macro assessment, Morgan Stanley presents two core investment recommendations covering the US bond and forex markets: US Bonds: Long Duration + Steepening Yield Curve, Potential to Increase Exposure in September Long 5-year US bond duration: 5-year US bonds have both "low volatility + high nominal yield" characteristics (current yield at 3.75%), which during a period of declining yields, duration strategies will directly benefit from price increases; at the same time, the sensitivity of 5-year bonds to rate cuts is higher than longer-term bonds, allowing for quicker capture of policy shift benefits. Steepening of the 3-year/30-year US bond yield curve: the short end (3-year) is directly influenced by Fed rate cuts, providing more room for yield reductions; the long end (30-year) is supported by economic outlook and deficit expectations, resulting in limited decrease, leading to a continued widening of the yield spread. The report recommends taking advantage of any flattening of the yield curve in September in the US bond index (expected extension of 0.07 years, above the monthly average) to increase exposure to steepening strategies (see Chart 4: 10-year US bond term premium residual regression, showing the current term premium is still at a low, with no upward pressure). Additionally, the report advises to exit short positions in 10-year Treasury Inflation-Protected Securities (TIPS) - current inflation expectations have synchronized with term premiums, with limited further downside potential and rising negative carry risks. Forex: Strongly Short the US Dollar, Euro and Yen Preferred Morgan Stanley's bearish stance on the US Dollar is clear, recommending hedging against downside risks to the USD by going long on the Euro (EUR) and the Yen (JPY), with the following core logic: Interest rate differentials further unfavorably affect the USD: the Fed rate cut is expected to be much larger than that of the ECB - ECB President Lagarde has clearly stated that the current 2% interest rate is close to a neutral level, making further rate cuts less likely; Morgan Stanley has increased its forecast for Germany's 2-year bond yield by 10 basis points for 2025; while the Bank of Japan might not be considering a rate hike yet, the market expectations for a narrowing of the US-Japan interest rate differential have been rising, significantly increasing the sensitivity of USD/JPY. USD negative risk premium may widen: since April, the USD Index has consistently been below the implied interest rate differentials, reflecting market pricing of uncertainties in US policies (Fed independence, trade policies). Though this negative premium has narrowed from 7%-8% to 6% recently, the report believes that factors such as the reliance of US-EU trade agreements on EU legislation, tariffs remaining a tool of US foreign policy, and uncertainty about policy continuity post Powell's tenure will expand this negative premium again. Investor positioning reversal: investors are no longer shorting the USD (Morgan Stanley USD positioning index has returned to neutral, see below), indicating that the pressure of "short covering on the USD during a downward trend has disappeared, leaving room for further decline. Specifically, the report suggests: maintaining a long position on EUR/USD (entry at 1.17, target 1.20, stop loss 1.11), shorting USD/JPY (entry at 147.40, target 135, stop loss 151), while going long on GBP/CHF (carry/volatility ratio ranking first among G10 currencies, entry at 1.084, target 1.12, stop loss 1.055). 3. Policy Analysis of Major Economies: Differentiation in Eurozone, UK, Japan Strategies In addition to the global trends, the report also provides differentiated strategies for major economies such as the Eurozone, UK, and Japan: Eurozone: Focus on Flattening of Yield Curve in October-December and Opportunities in September Rollovers Interest rate strategy: recommends entering the Eurozone 10-12 month yield curve flattening strategy (ECB December rate cut as the base scenario, short-term rates will decline faster), and tactical widening of OTC swap yield spreads during the September bond futures rollover period. Asset allocation: Germany 10-year bond yield target for the year-end raised to 2.40% (from 2.25% previously), Green bonds (FRTR 6/44) offer value for investment with significantly higher yields than the conventional curve. UK: Conclusion of the Bank of England's Interest Rate Hike Cycle, Maintain Short-term Rate Longs After the Bank of England voted 5:4 in favor of rate cuts in August, the market has priced in a total of 10 basis points of rate cuts by the end of the year. The report suggests: entering into MPC position for November (currently priced at a cumulative 5 basis points rate cut for November, reasonable risk-reward ratio), while maintaining a steepening strategy for 3-year/10-year UK bonds (increased supply of UK bonds in September, putting pressure on the long end). Japan: Buy 10-year JGB on Dips, Watch for Yen Volatility Though Bank of Japan Governor Kuroda did not mention the "wage-price upward cycle" in his Jackson Hole speech, indicating no immediate interest rate hikes, market expectations for the US bond yield decline have boosted sentiment for JGBs. The report advises to maintain a long position on 10-year JGBs and increase exposure if Breakeven Inflation rates significantly fall; USD/JPY may face short-term disturbances due to US non-farm payroll data, but the long-term downward trend is clear. 4. Risk Warnings: Three Factors that May Disrupt Asset Dynamics While Morgan Stanleys predictions for the second half of the year are clear, they also warn of three major risks: Fed rate cuts fall short of expectations: if US inflation stubbornly exceeds expectations (e.g. due to a rebound in energy prices) or non-farm payroll data remains strong, it could delay rate cuts, leading to a rebound in US bond yields and the USD. Geopolitical shocks: if tensions in the Middle East or conflicts in Europe escalate, the USD may strengthen in the short term due to safe-haven demand. Major central bank policies exceed expectations: if the ECB shifts to a more dovish stance due to an accelerated economic decline, or the Bank of Japan hikes rates earlier than expected, it could reverse the trends of the Euro and Yen. In conclusion: Asset Allocation Logic in the Start of a Rate Cut Cycle Morgan Stanley believes that in the second half of 2025, global assets will revolve around the main theme of Fed rate cuts, with US bond yields falling and the USD weakening as the core trends. Investors can focus on two main directions: capturing bond market dividends through long positions in 5-year US bonds and steepening strategies in the 3s30s yield curve, as well as non-USD currency opportunities through long positions in the Euro and Yen. Additionally, investors should closely monitor the September Fed rate meeting, US non-farm payroll and inflation data, and the pace of policy implementations in major economies to adjust their positions in response to short-term fluctuations.