Welcome to Thoughts on the Market. I'm Matt Hornbach, Global Head of Macro Strategy for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about global macro trends and how investors can interpret these trends for rates and currency markets. It's Tuesday, August 3rd, at 8 AM in New York.
Are U.S. Treasuries like used cars? That may sound like an offbeat analogy but let me explain. Since March, U.S. Treasury yields have fallen to valuations that many believe are quite rich. And this has many investors naturally wondering if prices will continue to rise as concern about reduced issuance collides with concern about delayed Fed tapering. So back to the comparison with used cars. In both cases, strong demand and the shortage of supply have lifted prices higher.
Let's start with used car prices. Since last year, a unique combination of the need for personal transport, a consumer flush with stimulus funds and excess savings, semiconductor shortages and auto industry supply chain constraints has ultimately meant that car prices - particularly used car prices - have risen at a pace into a price level never seen before.
And yet, there has always been the inevitability that these price increases won't be sustainable. As our autos equity analyst Adam Jonas has noted, while these shortages may provide a near-term "glow" to the auto sector, "secular challenges" remain. Used car prices for June showed the first price level decrease in months, suggesting that we may be nearing an inflection point from the peak level in prices.
The lesson here is that temporary shocks to supply and demand cannot overshadow fundamental drivers forever, and it's a lesson as applicable to used cars as to Treasury yields. Treasury demand from the Fed for a few more months, or well-advertised coupon issuance cuts, can only provide a boost to Treasuries for so long before ultimately the economy and the Fed's stance become the primary price drivers.
When it comes to the Treasury market, the biggest source of demand - and price insensitive demand, at that - is from the Fed. At a pace of $80 billion Treasury purchases a month, the Fed is buying almost $1 trillion in Treasuries every year for its quantitative easing program on top of its existing Treasury reinvestments. So, a shift in market expectations for when the Fed starts tapering can have a large impact on Treasury yields. To put it into perspective, a shift of only 3 months is worth $240 billion in net purchases, while a 6-month shift is worth nearly half a trillion dollars.
Since June, investors have pushed the timing of when the Fed lifts interest rates off the effect of lower bound further into the future. This so-called “Fed liftoff” has moved the market pricing of the first rate hike from December of 2022 to March of 2023. So, if the market prices a later liftoff from the Fed, then the market also is implying a later start to the Fed's tapering program. This implies additional demand from the Fed for U.S. Treasuries, and that almost certainly contributed to the recent rally in the Treasury market.
In addition to a later liftoff from the Fed, the market is also implying a shallower pace of rate hikes thereafter. If short-term rates ended up lower for longer, then demand for longer-duration, higher-yielding Treasuries should increase.
Of course, this implied increase in demand for Treasuries could reverse. And that is what we think will happen over the coming months. Economic data in the U.S. should remain robust and data in Europe should also rebound nicely, even as concerns around the Delta variant have increased uncertainty about that outlook.
As the economy improves, the Fed's dot plot should respond by projecting a higher target Fed funds rate in the coming years. As the dot plot pushes the projected Fed funds rate higher, and the Fed gets closer to liftoff, we expect the 10-year yield to move higher, driven by higher expectations for rate policy.
In addition, we expect infrastructure stimulus later this year to push term premiums higher. The combination of higher rate expectations and higher term premiums should lift 10-year Treasury yields to our 1.8% year-end forecast.
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