Morgan Stanley lists "Top 10 Surprises of 2025": Dollar depreciation ranks first

As 2024 is about to pass, on December 20th, Morgan Stanley analysts Matthew Hornbach and Andrew M Watrous led the global macro team to release the latest research report, outlining the top ten unexpected events that may occur in the global capital markets next year.

Specifically, Morgan Stanley expects that the U.S. fiscal deficit next year may not be as aggressive as anticipated, while fiscal spending in Germany and China will expand, which means that interest rates in the U.S., Europe, and China will converge, leading to a significant depreciation of the U.S. dollar. It is expected that the U.S. dollar index will be at the level of 101 by the end of next year, facing greater downside risks.

Secondly, Morgan Stanley anticipates that demand for U.S. Treasuries in 2025 will be stronger than expected, mainly driven by purchases from banks, foreign capital, and pension funds, which will keep long-term U.S. Treasury yields at relatively low levels.

Despite the market's generally pessimistic outlook on the euro, Morgan Stanley believes that under the scenario of stronger-than-expected interest rate cuts, trade shocks being less severe than anticipated, and large-scale capital repatriation, the euro is expected to "shine brightly."

U.S., Europe, and China interest rates converge, U.S. dollar may depreciate significantly

Morgan Stanley believes that the U.S. fiscal deficit is expected to decrease next year, while the fiscal deficits of China and Germany will increase, which may lead to the convergence of interest rates in the U.S., Europe, and China, subsequently triggering a significant depreciation of the U.S. dollar.

The nominated next U.S. Treasury Secretary, Becerra, previously stated that reducing the deficit-to-GDP ratio to 3% would be a priority. Morgan Stanley noted in the report that this commitment is generally considered difficult to achieve during the next presidential term, but there may be some progress by 2025.

The report indicates that considering U.S. fiscal policy may become more conservative by 2025, U.S. Treasury yields will decline to levels lower than expected. Morgan Stanley expects that the U.S. dollar index may reach 101 by the end of 2025, with increased downside risks.

Regarding Germany, the largest economy in the Eurozone, the report believes that the upcoming elections in February next year will reduce policy uncertainty with the formation of a new government, thereby boosting economic growth and providing more room for fiscal spending.

The report predicts that Germany's economic growth rate in 2025 will reach 0.8%, exceeding the general expectation of 0.6%.

As of the time of writing, the U.S. dollar index is reported at 107.97.

Strong recovery in demand for U.S. Treasuries, long-term yields remain low

The report believes that demand for U.S. Treasuries in 2025 will be stronger than expected, mainly driven by purchases from banks, foreign capital, and pension fundsBased on the expectation that inflation and deficit prospects from Trump's return to the White House will push up long-term U.S. Treasury yields, investors have been selling long-term U.S. Treasuries in the fourth quarter of this year. However, Morgan Stanley does not agree with this view and expects long-term U.S. Treasury yields to remain at relatively low levels until next year.

The report states that the downward trend in long-term U.S. Treasury yields next year will not only increase buying pressure but also that structural demand may be stronger than expected, primarily from banks, foreign capital, and pension funds.

From the banking perspective, the increased uncertainty regarding the Federal Reserve's policy path will lead banks to increase their holdings of U.S. Treasuries, especially as the medium- to long-term U.S. Treasury outlook becomes more "attractive," as the positive holding period yield (U.S. Treasury yield > overnight index swap rate) will continue to attract demand.

For foreign investors, the focus will shift to the impact of the new government's fiscal policy on negative growth, thus the expectation of interest rate cuts has revived foreign demand for U.S. Treasuries.

The report cites that Japanese investors have been on the sidelines over the past year, but attractive arbitrage trades and hedging costs will shift investment returns from Japan to non-yen bonds.

Regarding pension funds, the report believes that their asset surplus situation is good (the market value of assets exceeds the present value of future liabilities), and these funds will rebalance their portfolios and choose de-risking strategies, shifting from stocks to long-term government bonds, especially when long-term interest rates remain high while stocks continue to rise.

Euro Performance Shines

The report believes that despite the market's pessimism towards the euro, low expectations mean that Europe is more likely to exceed expectations, especially with private consumption driving growth.

Trump's return to the White House has raised concerns about trade policies globally, putting pressure on an already challenging economic outlook for Europe. However, Morgan Stanley believes that despite the generally pessimistic expectations, the European economy may actually deliver surprises.

On one hand, Morgan Stanley believes that the fundamentals of trade policy may not be as aggressive as many investors fear, particularly regarding policies related to Europe, and the euro still contains "quite a bit" of trade-related risk premium.

The report adds that the market has underestimated the extent of the European Central Bank's current interest rate cut cycle by about 75 basis points, and it can be anticipated that under greater stimulus from interest rate cuts, the economy still has room for upward movement.

Better-than-expected economic growth, unexpected favorable political news both domestically and internationally, and lower expectation thresholds are all factors that may prompt domestic and foreign investors to reallocate capitalOn the other hand, the report believes that capital repatriation is a particularly important potential surprise area. Taking the 10-year government bond as an example, the nominal yield of U.S. Treasury bonds is more than 200 basis points higher than that of German government bonds, but once foreign exchange hedging costs are taken into account, this yield advantage disappears.

Although Morgan Stanley expects yields in both the U.S. and Europe to decline, the fact that the U.S. curve is unlikely to experience a meaningful inversion suggests that if the situation in Europe begins to show unexpected upside, European investors may be willing to deploy more capital in Europe.

The report also states that despite the market's generally pessimistic stance on the euro, the euro/USD has been trading within a fairly narrow range, and if investor bearish sentiment experiences a significant surprise, it could push the euro/USD to break above the range.

The Bank of England shortens the rate cut cycle, and the Japanese bond yield curve flattens...

In addition to the above three points, the report also presents the following potential "surprise" events that may occur in 2025:

The SOFR (Secured Overnight Financing Rate) swap spread curve flattens. The issuance of U.S. Treasury securities falls short of expectations, leading to an expansion of swap spreads. The Federal Reserve may increase purchases of short-term U.S. Treasury bonds to adjust the maturity structure of its balance sheet.

The Bank of England shortens the easing cycle. Persistent inflation limits the Bank of England's ability to further cut interest rates, thereby constraining the performance of the UK government bond market.

The Japanese government bond curve flattens. In the event of a hard landing in the U.S. economy or if Japanese wage growth falls short of expectations, the yield curve of Japanese government bonds may experience a bull flattening rather than a bear flattening.

The yield curve of 10/30-year European bonds flattens. Although the macro backdrop supports a steepening of the 10/30-year European bond yield curve, the European Central Bank's rate cut measures and slight repricing of volatility may expose this position to risks in the first few months of 2025.

The dollar may not react much to tariffs. The dollar is unlikely to be significantly affected by aggressive tariff policies, but if this occurs in the context of a slowdown in U.S. economic growth or if the Federal Reserve's response is more sensitive than that of other central banks, it could pose downside risks to the dollar.

U.S. inflation expectations decline. Although the policies of the Trump administration may be seen as boosting inflation prospects, if the destruction of demand and the impact of tariffs outweigh initial inflation, inflation expectations may decline.

Emerging market local bonds rebound. Due to a weaker dollar, emerging market local currency bonds may perform well, especially high real yield bonds from countries like Brazil, Mexico, Indonesia, and South Africa