Is it time to sell dollars and buy U.S. Treasuries? Morgan Stanley: The possibility of a rate cut in March is very high

Currently, the market expects the Federal Reserve to cut interest rates less than twice this year, but Morgan Stanley believes: that's too few!

On January 16th, Eastern Time, Morgan Stanley economists released the latest research report, predicting that the Federal Reserve will first cut rates by 25 basis points in March 2025, and may cut rates again in June. The report points out that the core PCE inflation data for January 2025 is expected to decline, which will support the Fed's rate cut in March.

Morgan Stanley also believes that U.S. Treasury yields may have peaked and is optimistic about the future of the U.S. Treasury market. Considering that the Fed may cut rates in March, combined with the recent continuous rise in U.S. Treasury yields after the U.S. elections, Morgan Stanley believes this is a good opportunity for investors to enter the U.S. Treasury market and recommends increasing holdings in 5-year U.S. Treasuries.

In addition, Morgan Stanley points out that U.S. Treasury yields may decline in the future, which is an important catalyst for the depreciation of the U.S. dollar. Therefore, Morgan Stanley recommends selling dollars and buying euros, pounds, and yen.

01 Reasons for the First Rate Cut in March

Morgan Stanley believes that the core PCE inflation data for January, to be released in February this year, will decline, predicting that the year-on-year growth rate of core PCE inflation in January will drop from 2.8% in December to 2.6%, indicating that inflation continues to approach target levels. The reasons are:

1. Federal Reserve officials are more optimistic about the inflation outlook. Recently, several Federal Reserve officials have become more confident that inflation will continue to decline. Federal Reserve Governor Christopher Waller stated that inflation will continue to decline in the first quarter of 2025. The "third in command" of the Federal Reserve, New York Fed President John Williams, said that the process of inflation decline is still ongoing. Richmond Fed President Thomas Barkin believes that the latest CPI report continues to support our long-held view that inflation is moving toward target levels.

2. Data from November and December both show that U.S. inflation continues to slow down. In the November inflation data, rent and owners' equivalent rent (OER) significantly decreased, while the CPI and PPI data for December released this week further enhanced signs of inflation slowing down.

3. The increase in financial services inflation in January 2025 will be smaller than in January 2024, as the acceleration of inflation in the first quarter of 2024 was mainly related to strong PCE financial services data, particularly the "portfolio management and advisory" component related to past stock returns. In November and December 2023, U.S. stock returns were particularly good, leading to a significant increase in prices in the financial services sector in January 2024.

However, the average monthly return of U.S. stocks in November and December 2024 was 1.9%, lower than the average of 4.8% in the same period of 2023, so it is expected that the inflation increase in the "portfolio management and advisory" component in January 2025 will be more moderate.

However, Morgan Stanley emphasizes that several factors will affect this expectation from now until the Fed's meeting in March, and investors should still pay attention to the following risks:

1. If the U.S. government raises tariffs in advance, prices may rise in the first quarter of next year, as changes in tariff policy will affect the prices of imported goods, which will ultimately be reflected in the CPI.

2. Secondly, if the U.S. government's immigration policy tightens, it may lead the Fed to maintain high interest rates for a longer period, as changes in immigration policy may affect the number of job seekers, which will impact wages and, in turn, the overall inflationary pressure

3. California wildfires may continue to push up core prices. Generally speaking, the Federal Reserve does not pay much attention to short-term factors affecting prices, but the destructive power of the California wildfires is too great, and their impact on commodity prices may last more than a month.

However, Morgan Stanley believes that current market prices have already taken these uncertainties into account, and even if the U.S. government wants to raise tariffs, it will be a gradual process. The speed and intensity of efforts to expel illegal immigrants are also limited. Therefore, there is no need to worry too much about prices rising immediately; a rate cut in March is still quite possible.

02 Recommendation to Increase Holdings in U.S. Treasuries

Therefore, based on the above analysis, Morgan Stanley believes that U.S. Treasury yields may have peaked, and they are optimistic about the investment prospects of U.S. Treasuries, recommending investors to increase their holdings of 5-year U.S. Treasury bonds.

In addition, Morgan Stanley pointed out other favorable factors supporting the rise of U.S. Treasuries:

On one hand, technical indicators have shown favorable signals for bond investments. U.S. Treasury yields reached a peak last week, but the Moving Average Convergence Divergence (MACD) indicator did not reach a new high, indicating a clear divergence between these two data points.

On the other hand, market prices already include a considerable amount of term premium. Morgan Stanley noted that, based on current market conditions, the expected future policy rate is around 4%, which is similar to the current policy rate and significantly higher than the median long-term rate deemed appropriate by Federal Reserve officials.

Morgan Stanley believes that the gap between the market's expected minimum rate and the long-term rate considered appropriate by Federal Reserve officials is about 100 basis points, and this excess can be viewed as a term premium. Compared to the past year, the current term premium is closer to its peak rather than its lowest point. When pricing U.S. Treasuries, the market has already considered a lot of risks related to potential uncertain impacts on the economy and prices due to changes in fiscal policy, resulting in a relatively high term premium.

03 Bearish on the U.S. Dollar

Morgan Stanley believes that now is the right time to take a short position on the U.S. dollar, as the dollar index has at least tactically peaked. The reasons are:

First, a key driver for being bearish on the dollar is U.S. interest rates. U.S. Treasury yields have peaked and will begin to decline. This is important because the direction of U.S. fixed income has been the ultimate driver of most market dynamics, including the dollar, this year.

Second, the market has fully digested favorable factors, which has led investors to widely hold large long positions in the dollar. Relevant news has been fully understood and absorbed by the market, and therefore is likely already reflected in prices. Thus, Morgan Stanley believes that the asymmetric risk/reward is more inclined towards a decline in the dollar rather than further strengthening.

Third, tariff policies may disappoint investors. Currently, investors have overly high expectations for U.S. tariff and fiscal expansion policies, which may pose risks to the market. Many investors expect President Trump's inaugural address to detail a large-scale tariff plan and implement it quickly. However, the tariff policies announced by the new administration in the early stages may disappoint investors in terms of scale, scope, and implementation speed. This will provide tactical opportunities for dollar bears, as trade-related risk premiums may be repriced

Fourth, as the deadline for the current U.S. government funding bill approaches in mid-March, investors may pay more attention to fiscal policy. Relevant negotiations at that time may reveal more specific details of budget proposals, especially what will not be included in the budget. If the budget proposal has limited fiscal expansion, its positive impact on U.S. economic growth will also be limited, which may weaken market expectations for the "American exceptionalism," thereby affecting the dollar's trend.

The research report specifically mentions that if Congress fails to pass the full-year appropriations bill by April 30, it may trigger automatic cuts to discretionary spending later this year. Morgan Stanley analysts are closely monitoring how Congress responds to this potential risk.

Fifth, the long positions in the dollar are too crowded. Morgan Stanley found that the market is currently very inclined to buy dollars, especially compared to European currencies like the euro and the pound, where everyone is more willing to hold dollars. However, this increases the risk for the dollar, as if everyone is buying dollars, any sudden market movement could lead many to sell dollars simultaneously, which could easily cause a pullback in the dollar index.

Sixth, the dollar may face tactical selling in the short term. Although the medium-term trend of the dollar ultimately depends on the U.S. economic and policy situation, in the short term, it is likely that some people will sell dollars for various short-term reasons, which is tactical selling. Moreover, it now appears that the risks of a weaker dollar and declining U.S. Treasury yields are much greater than the risks of a stronger dollar and rising yields.

04 Euro and Yen Expected to Rebound

In terms of investment strategy, Morgan Stanley believes that the market is overly pessimistic about the European economic outlook, which means there is a greater likelihood of positive surprises in European economic data, and the chances of the European economy improving are greater than deteriorating. Among them, inflation data and the German election are key to the euro's trend:

Regarding inflation data: The January Eurozone CPI data to be released on February 3 is crucial and will set the tone for European inflation trends. If the inflation data exceeds expectations, it may lead the market to reassess the European Central Bank's rate-cutting cycle, which would be good for the euro and could strengthen it.

Regarding the German election: Investors are cautious about the results of the German election. If the election results favor political and economic stability, the risks facing the euro will decrease, pushing the euro to rise against the dollar.

Morgan Stanley also pointed out that the dollar against the yen may become the preferred choice for shorting the dollar for the following reasons:

First, interest rate factors. When U.S. interest rates decline, the dollar against the yen currency pair is very suitable for shorting the dollar. This is because the dollar-yen exchange rate is closely related to U.S. interest rates; when U.S. rates drop, the dollar-yen exchange rate is likely to follow suit, allowing for profit through shorting this currency pair.

Second, expectations for the Bank of Japan to raise interest rates are increasing. If the Bank of Japan raises rates in January (which is the basic expectation of Morgan Stanley economists), it will also provide marginal support for the yen.

Third, Trump's remarks may affect the trend. Historical data shows that tariff announcements usually have a negative impact on the dollar-yen exchange rate on the day they are announced. Finally, Trump has previously expressed a desire for a stronger yen, and if he makes similar remarks again, it may further boost the yen