Morgan Stanley: "Ten Unexpected Events That Could Impact the Global Market in 2024"

In 2023, the financial markets are in turmoil, with high interest rates, high inflation rates, and high debt levels sweeping across Europe and the United States. The turbulence continues, so what "unexpected" events will occur in 2024?

On December 16th, Morgan Stanley strategist Matthew Hornbach and his team released a report titled "Top 10 'Unexpected' Events in 2024". According to Morgan Stanley, a year without surprises is the real surprise. They believe that the occurrence of the following 10 events in 2024 may have far-reaching impacts on the global macroeconomy:

1. Unexpected Event: "Shock" to the US Economy - A hard landing "although delayed" - The expansionary fiscal policy in the United States supported consumption and economic resilience, avoiding a recession in the US economy in 2023. However, it will be difficult to sustain the loose fiscal policy in the United States in 2024, and the economic growth rate will significantly decline. The high interest rates and high debt levels faced by the US government, as well as the lagging effects of the Federal Reserve's interest rate hikes, may have a negative impact on economic growth.

2. Unexpected Event: "Surprise" to the US Economy - 8 rate cuts by the Federal Reserve, leading to a "soft landing" of the US economy. The focus of the Federal Reserve is to maintain real interest rates at a low level when inflation declines, which will flatten the yield curve and create strong demand for long-term government bonds.

3. Unexpected Event: The end of Quantitative Tightening (QT) by the Federal Reserve before the first rate cut in June. The end of QT may be to alleviate the pressure on the financial markets, the deterioration of financial institutions' balance sheets, the increase in structural demand for reserves, or the continuous liquidity demand from banks.

4. Unexpected Event: The decrease in the spread between Italian government bonds (BTP) and German government bonds (Bund). Market views on the fiscal and economic risks of the two countries may change due to changes in their fiscal policies or economic conditions.

5. Unexpected Event: The narrowing of the yield spread between 10-year and 30-year government bonds in the Eurozone. Due to the sharp deterioration of the macroeconomic situation in Europe, the yield on 30-year bonds may be 50 basis points lower than that of 10-year bonds.

6. Unexpected Event: The Bank of England cuts interest rates earlier than expected. Although it is generally expected that the Bank of England's easing cycle will lag behind, the recent momentum in inflation and economic data may support an earlier-than-expected interest rate cut by the Bank of England.

7. Unexpected Event: The yield curve of Japanese government bonds becomes steeper instead of flattening. The market unanimously expects the Bank of Japan's monetary policy to gradually normalize, but if the signal for normalization is later than expected, the curve may become steeper (short-term interest rates will not rise rapidly).

8. Unexpected Event: The British pound enters an upward trend. The extremely low economic data base in 2023, low asset valuations, and the possibility of increased economic cooperation between the UK and the EU lay the foundation for the potential appreciation of the British pound.

9. Unexpected Event: The pricing of r* (neutral interest rate) in Australia and Canada decreases. Due to weak productivity and risks in commodity prices, medium-term interest rate expectations will fall below recent average levels.

10. Unexpected Event: The yield on US inflation-protected bonds (TIPS) returns to pre-2019 levels. The spread between 5-year TIPS and 30-year TIPS will return to the average level between 2013 and 2019, which is 20 basis points.

The Biggest "Shock" in 2024: The Hard Landing of the US Economy is "Late but Coming"

Morgan Stanley pointed out that the biggest surprise of the US economy in 2023 is not the absence of a hard landing, but the "no landing". Although monetary policy tightened in 2023, fiscal policy expanded significantly, with a deficit rate of 6.4%. This supported consumption and economic resilience, avoiding a recession in the US economy in 2023.

Morgan Stanley bluntly stated that most investors in 2024 are betting on a "soft landing" and assuming that this tightening cycle is "different". However, this expectation ignores the important role of fiscal policy in the economy. Fiscal policy exacerbates the long-term impact and lagging effects of monetary policy, and the recession in 2024 may be more severe. As a result, the Federal Reserve is forced to quickly adjust its policies to restore interest rates to a neutral level:

The notion of a soft landing always makes investors feel "this time is different," which is the most dangerous phrase in the financial world. The biggest "surprise" in 2024 may be that the elusive hard landing finally arrives.

The combination of fiscal policy and monetary policy can explain why the US economy did not land in 2023, and it can also explain why there may be an economic hard landing in 2024. In 2024, it is expected that the loose fiscal policy in the US will be difficult to sustain, and the economic growth rate will significantly decline. The Federal Reserve may not implement obvious stimulus policies, and the failure of expectations may keep the economy in a low-growth environment.

Morgan Stanley explained that the combination of fiscal policy and monetary policy in the US this time is different from the past, and this combination may exacerbate the volatility of the economic cycle:

Although the Federal Reserve's benchmark interest rates are 120% higher than in 2019, the interest paid on reserve balances by the Federal Reserve has increased by 364%, and the interest paid on US Treasury bonds by the US Treasury has increased by 406%.

The interest on US Treasury bonds accounts for more than 1% of nominal GDP each year. Overall, the Federal Reserve and the US Treasury have injected interest equivalent to 1.75% of GDP into the economy.

In order to make up for this massive deficit, US authorities may borrow more and more debt, making the debt mountain even larger. Under high interest rate levels, interest payments on federal public debt will soar, which may further exacerbate the deficit problem and plunge the US fiscal policy into a vicious cycle.

Morgan Stanley's analysis states that this countercyclical stimulus caused by fiscal policy combined with the broadly neutral stance of monetary policy has stimulated the economy. However, the policy environment in 2024 may be more stringent, with increased policy restrictions globally, reduced support from the US federal government's fiscal policy, and increased uncertainty related to the US presidential election, all pushing the economy towards a hard landing: The Federal Reserve's forecast for the economy and monetary policy at the December 2023 FOMC meeting indicates that the strictest policy stance since Volcker is imminent. The Fed is well aware of how the 2024 US election will affect business and consumer confidence, and subsequently impact investment decisions.

As the number of unemployment benefit applications soars and income and spending growth slows to a halt, consumer confidence has plummeted, reducing the marginal propensity to consume remaining savings. Core PCE has approached a YoY increase of 2% in the second half of 2023. With monetary policy entering a restrictive range and fiscal policy support gradually weakening, it is expected that the YoY growth rate in the first half of 2024 will be below 2%.

Due to the possibility of the YoY core PCE inflation rate falling below 2% in the first half of next year, at least 18 months earlier than predicted by the FOMC, it is expected that the Fed will cut interest rates by 25 basis points at the March 22nd meeting, followed by another 25 basis point cut at the May 3rd meeting. As economic data further signals a recession, the Fed will cut interest rates by 50 basis points at each remaining meeting in 2024.

"Surprise" in the US Economy in 2024: 8 Interest Rate Cuts, Soft Landing

Morgan Stanley believes that the market currently expects moderate positive growth in the US economy in 2024. However, if the Fed cuts interest rates a total of 200 basis points in 8 moves, bringing the benchmark rate close to a "neutral" level, this will ensure a "soft landing" for the US economy:

The "soft landing" finally arrives in 2024, with core PCE stabilizing at around 2% and achieving moderate growth (consistent with our US economic team's view). Although the Fed has opened the door for rate cuts at the December policy meeting, the Fed will ultimately complete 8 rate cuts in 2024 (far more than the latest dot plot's 3 rate cuts), even exceeding the market's current expectation of approximately 6 rate cuts.

Morgan Stanley points out that theoretically, the market's reaction to the Fed's 8 rate cuts should result in a "bull steepening" of the yield curve. However, another "surprise" based on the Fed's 8 rate cuts in 2024 is that the yield curve will flatten instead:

The "bull flattening" of the yield curve may be caused by various factors - (1) the steepening of the yield curve becoming a highly consensual strategy, (2) pension funds and insurance companies increasing their allocation to ultra-long-term bonds to quickly make up for underallocation, and (3) retail investors seeking yield and choosing to "lock in" high yields on long-term government bonds. In addition, due to the market already pricing in 6 interest rate cuts by the Federal Reserve, short-term bond yields are low, which is not favorable for investors to achieve higher total returns. On the other hand, long-term bonds have lower holding costs and are more attractive.

It is expected that the demand for long-term US bonds from US banks, foreign central banks, and hedge funds will recover next year, causing long-term interest rates to decline more than short-term interest rates. This will result in a flatter yield curve, presenting a "bull market flattening" trend.

The Unexpected Move by the Federal Reserve: Ending Quantitative Tightening (QT) Before the First Interest Rate Cut

According to Morgan Stanley, an unexpected event for the Federal Reserve in 2024 would be the pressure on funds that forces them to end quantitative tightening (QT) before the first interest rate cut in June. The end of QT could be to alleviate pressure on financial markets, worsening balance sheets of financial institutions, increasing structural demand for reserves, or ongoing liquidity demand from banks.

Our baseline assumption is that the Federal Reserve will gradually start to exit QT in September and stop balance sheet reduction in early 2025. However, there are tail risks to funding conditions and market operations that could lead to the Federal Reserve exiting QT before the interest rate cut in June.

First, due to the role of overnight reverse repurchase agreements (RRP), the Secured Overnight Financing Rate (SOFR) is still in an upward trend. RRP is very sensitive to higher repo rates, which limits the extent of SOFR's increase.

However, starting from the mid-first quarter of 2024, the intermediation capacity of broker-dealers (borrowing cash in RRP and lending to investors) in the repo market is disrupted due to the accelerated supply of US Treasury bonds.

With the increase in Treasury bond supply, broker-dealers may need to hold more Treasury bonds to meet trading demand. At the same time, if there is an increase in demand in the repo market, they may need to borrow more funds to help purchase Treasury bonds. These operations will increase their balance sheet burden.

This has led to an increase in the spread between the General Collateral Financing (GCF) and the Treasury General Collateral Rate (TGCR) to more than 25 basis points, making the volatility of SOFR more significant in the coming months. The pressure on these balance sheets and the resulting higher funding costs subsequently prompted leveraged investors to unwind cash-futures basis trades, exacerbating pressure in the repo market.

Second, as banks continue to lose interest-free deposits, the structural demand for reserves will further increase in the first half of 2024. This may prompt banks to hold more liquidity, keeping reserves at higher levels (around $3.5 trillion).

This will result in the depletion of RRP before the third quarter of 2024 in our baseline scenario, and banks will become lenders in the repo market earlier than expected. At the same time, the higher structural demand for reserves will limit banks' willingness and ability to lend cash to the Federal Reserve, leading to volatility in SOFR and subsequent funding pressures. In addition, the uneven distribution of reserves further exacerbates the marginal risk of financing, and small banks have also increased their demand for reserves, driving up SOFR and EFFR (Effective Federal Funds Rate).

Third, the Federal Reserve's Quantitative Tightening (QT) plan is also facing threats outside the repo market, as the Federal Reserve cannot prove the rationality of extending the Emergency Loan Program BTFP after March, and bank liquidity pressures continue to increase, leading to a new round of bank pressures in the second quarter of 2024. In the past six weeks, BTFP has increased by $14 billion, reaching a new high of $126 billion.

Morgan Stanley believes that in order to cope with the unexpected financing pressure in the first half of 2024 and the Federal Reserve's exit from the QT plan, investors can turn their attention to the steep position of the 2-year to 10-year SOFR (overnight repo rate) swap spread. (A strategy that uses interest rate swap contracts for investment, investors expect the 2-year rate to be lower relative to the 10-year rate):

The sudden end of QT should stimulate investors' demand for long-term US bonds, causing the 10-year swap spread to expand relative to the 2-year spread. This trade has better holding costs compared to shorting the 2-year swap spread directly, especially considering the pricing of the 1-month SOFR/Federal Funds Rate futures (FF) next year.