Two weeks after taking Bill Dudley to task on his suggestion that the worst isn’t over for US Treasurys, Morgan Stanley strategists including Matthew Hornbach said “any dip” in bonds should be bought.

“FOMC participants remain as hawkish as ever,” Hornbach and co. wrote, commenting specifically on remarks by Chris Waller, who spoke in the aftermath of last week’s cooler-than-anticipated CPI and PPI reports in the US.

Waller argued for shorter lags between policy tightening and the impact of that tightening on the real economy. In a nutshell, he suggested that if last year’s tightening worked its way through expeditiously, and if the Fed therefore can’t expect additional drag from 2022’s rate hikes, then additional tightening is probably necessary given the ongoing resilience of the US growth impulse.

Before analyzing that assessment, Hornbach briefly recapped how the New Keynesian model and impulse response functions fit in. On the former, he reminded clients that growth can be explained by the level of actual rates relative to the neutral rate. The impulse response function, which Waller discussed in his July 13 speech, looks at the read-through for growth of “unexpected” policy changes, or “shocks.”

Don’t lose the plot. This is fairly simple. If the policy rate is higher than the neutral rate, growth will slow. If policy rates are unexpectedly raised even further, growth will slow even more over the short- to medium-term.

Long story short, Morgan Stanley is “concerned” (their word) that Waller didn’t address, answer or reconcile a number of questions raised implicitly by his remarks.

“If Waller believes that r > r-star at present, and he has in mind broadly accepted NK models, then he should also believe that previous tightening should generate more slowing of demand and inflation,” Hornbach wrote. If, instead, Waller meant the Fed probably can’t depend on additional tightening from the “shock” element of previous rate hikes, then he (Waller) needs to explain the rapid rise in short-end yields which, before plummeting last week following the June inflation updates, reached a new cycle high in and around a scorching read on private sector hiring in the US.

“Waller argues that the ‘two-year Treasury yield is a good proxy for the stance of monetary policy,’ and we have sympathy with this view [but] two-year Treasury yields rose by ~100bps since mid-May, and our proxy effective fed funds rate rose even more,” Morgan Stanley’s team wrote. “Using Waller’s framework, this unexpected policy tightening should slow demand and inflation further, contrary to his contention.”

The figure above is instructive, and it’s not as esoteric as it might seem at first glance. It’s just core PCE plotted with the difference between Morgan Stanley’s proxy for the real funds rate and the New York Fed’s neutral rate estimate, with the two additional rate hikes implied by the June dot plot appended to the end (the dark mustard-colored area with the annotation).

“The stance of monetary policy… is set to become much more restrictive than it had been over the past 30 years [so] the downward pressure on growth should only increase, even if it’s not pressure coming from unexpected policy shocks,” Hornbach went on.

The implication: If the dot plot isn’t a gambit, then this is a Fed which risks keeping policy “overly restrictive for too long, raising risks of a larger-than-expected decline in growth and inflation.” That, in turn, makes bonds look even (and ever) more appealing.

If you’re wondering whether last week’s rally suggests the bull case is already exhausted, the answer for Morgan Stanley is “No.” “Over the last week, five-year yields have dropped ~35bps, helped in large part by a fairly weak inflation print that we think heralds an exit from the sticky inflation range,” Guneet Dhingra said. “We see more to go in the current rally and target five-year yields around 3.5% for now.”

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