How low can U.S. Treasury yields go? Morgan Stanley: Below 4%!

U.S. Treasury yields have recently fallen below important technical support levels, approaching the 200-day moving average. Since Trump's election, many factors that led to rising yields since last September have almost all reversed, with only the Federal Reserve's "curse" still ongoing.

Morgan Stanley believes that U.S. Treasury yields are highly correlated with the market-implied federal funds rate bottom, and there is room for further declines in rates. If the market-implied federal funds rate bottom falls from the current level of around 3.65% to 3.25% by October 2024, then the 10-year U.S. Treasury yield could drop below 4.00%.

Multiple Factors Reverse, Only "Hawkish" Voices Remain

In a report on February 26, Morgan Stanley stated that since last September, buyer strikes, momentum-driven duration reductions, macro funds' reflation trades, and the Federal Reserve's hawkish turn have collectively catalyzed rising yields.

However, after Trump officially took office, almost all of these factors have reversed: the buyer strike ended, momentum-driven selling turned into momentum-driven buying, and macro funds began to question their reflation trades. Part of the reason behind this is the negative impact of Trump's immigration policies on economic growth, as well as news of budget cuts from the Department of Efficiency (DOGE).

But compared to before the presidential election, the comments from Federal Open Market Committee (FOMC) participants remain hawkish. Market pricing also confirms this view, as the market-implied federal funds rate bottom is still higher than the levels before the December FOMC meeting.

In addition to inflation factors, potential cuts in government spending also exert downward pressure on U.S. Treasury yields.

Morgan Stanley points out that investors are increasingly focused on the cost reductions that the Department of Efficiency (DOGE) may bring. By monitoring the performance of a basket of stocks related to federal spending, it can be observed that market expectations for government spending cuts are rising. If this expectation spreads to the interest rate market, then the market pricing of the neutral rate may face downward risks.

U.S. Treasury Yields Have Further Downward Space

Morgan Stanley states that the market pricing of the federal funds rate bottom is closely related to long-term Treasury yields. There is a positive correlation between the market-implied federal funds rate bottom and the 10-year U.S. Treasury yield.

In other words, the market's expectations of how low the Federal Reserve will ultimately lower rates directly affect the pricing of U.S. Treasuries. If market expectations for a Federal Reserve rate cut strengthen, then U.S. Treasury yields have further room to decline.

According to the bank's analysts' calculations:

If the market-implied federal funds rate bottom falls to the post-election low of 3.40% (-25 basis points), the 10-year U.S. Treasury yield could drop by another 21 basis points from 4.30% to 4.09%.

If the market-implied federal funds rate bottom falls to 3.25% in mid-October (-40 basis points), the 10-year U.S. Treasury yield could drop by another 33 basis points from 4.30%, falling below 4.00% Analysts currently expect that the core PCE inflation rate to be released this Friday will reach a year-on-year low of 2.58% and will decline significantly in the coming months.

This trajectory aligns with their prediction of a rate cut in June—markets currently estimate the likelihood of this event to be around 50%. Additionally, the market's estimate for a rate cut in May is much lower (around 20%)