Bond yields should be higher. It’s easy to make the case. I do it all the time. Typically by reference to purportedly “epochal” macro shifts tied to the pandemic and the war(s).
Bond yields should be lower. It’s (fairly) easy to make the case. I do that all the time too. Typically by reference to a purportedly “imminent” recession that’s destined to come knocking once “long and variable lags” finally catch up to us.
So, yeah: I argue both sides of the coin. Habitually. That’s part of it, folks. If you can’t articulate both sides of a debate, chances are you’re not so sure about your own position.
Anyway, I ran across a mildly interesting version of the “yields should be lower” argument on Tuesday. It’s worth mentioning, however briefly, because it ties in directly to the immigration discussion from “Enjoying US Economic Exceptionalism? Thank Immigration,” published here last week. In that piece, I summarized Goldman’s take on labor market normalization and the extent to which elevated immigration, by boosting the labor force, might’ve lifted potential GDP growth.
For their part, Morgan Stanley pointed to a disparity between 10-year yields and falling core inflation, even accounting for the dramatic bond rally which played out in November and December. The simplest of simple figures, below, illustrates the point.
The easy explanation says bond yields are stubborn because notwithstanding their dovish inclinations (“worst impulses,” as critics might put it), the Fed won’t ultimately be able to cut rates rapidly or deeply in the face of a resilient economy and a still-tight labor market.
Morgan Stanley’s US rates team thinks that explanation’s wrong. Or at least too simplistic and thereby incomplete.
Instead, the bank said the same increase in labor supply mentioned above (i.e., the bump from elevated immigration) largely explains 2023’s economic and labor market resilience, and also “adds a lagged disinflationary effect” which markets have yet to wake up to.
The figure above shows Morgan Stanley’s model of 10-year yields assuming they tracked core PCE surprises.
The disparity’s rather glaring, and the bank thinks it’ll probably resolve with lower yields as markets belatedly come to terms with the reality of last year’s macro dynamics.
“If Treasury yields had followed [their] previous relationship with inflation surprises, 10-year yields would be around 3.60% today,” the bank said.
Food for thought, if nothing else. That’s ~60bps lower, a meaningful opportunity if you buy the argument.
I manage my 90 year old father’s portfolio on his behalf. 100% in USTs.
He has some USTs maturing on March 31 which I will reinvest; just as this post suggests.
I feel better already.
I’m not one to quibble with Morgan Stanley and am not familiar with the length of the time series’ behind their model, but the immigration-led disinflationary growth thesis feels reachy to me. I mean it’s interesting and I hope it’s true, but is it really too simplistic to think that after an unusual and unusually persistent stretch of negative reals, nominals are not going to march in lockstep back down with inflation, after chasing it for 3+ years? Reals are up 300 bp in a little over 2 years. but are only back to what not too long ago were considered “normal” levels. Maybe this is just the new normal until the market, like the Fed, “has gained greater confidence that inflation is moving sustainably down toward 2 percent.” But while the Fed may be broke, it’s bondholders who got burned (or burned up if you were an unlucky bank). So maybe it’s just a little risk premium, or a catch up bonus if you like, gumming up the works a bit.
It’s hard to side with Ian Hunter and Mick Ronson over Morgan Stanley here, but they were warning about exactly this kind of thing way back in 1975 (with a hat tip, likely, to Aesop). And you didn’t need charts — just a radio.