Under the triple "perfect storm," is a bull market for U.S. Treasuries approaching?

Accompanied by the deleveraging of the U.S. private sector, the further expansion of Trump’s tariffs, and the repricing of the Federal Reserve's interest rate cut path, U.S. Treasuries may be on the eve of a bull market.

Morgan Stanley's analyst team led by Matthew Hornbach recently released a research report indicating that the U.S. is facing a triple "perfect storm": accelerated deleveraging in the private sector, escalating trade frictions (Trump is expected to announce reciprocal tariffs on April 2), and the market repricing the Federal Reserve's interest rate cut path. This will drive U.S. Treasury yields further down, with the 10-year Treasury yield potentially falling to 3.85% or even 3.75%.

Deleveraging in the Private Sector as an Economic Concern

The Z.1 Financial Accounts report released by the Federal Reserve on March 13 shows that in the fourth quarter of 2024, the U.S. private sector is experiencing the largest scale of deleveraging since the financial crisis.

The Morgan Stanley report points out that although the federal government deficit as a percentage of GDP reached 8.8% in the fourth quarter of 2024 (the largest quarterly increase in 2024), the ratio of private sector debt to GDP decreased by 2.4%. This deleveraging trend indicates that businesses and households are reducing debt, leading to a cooling of economic activity.

More concerning is that this deleveraging involves all non-financial domestic sectors: households, non-financial enterprises, and state/local governments. The fourth quarter of 2024 marks the first time all three sectors have simultaneously reduced leverage in the same quarter, a situation that did not even occur during the financial crisis.

Morgan Stanley believes that the reduction in private sector leverage coincides with the timing of the U.S. elections, which may explain the decrease in borrowing activity. Meanwhile, the intensification of trade tensions following the presidential inauguration may limit any rebound, as indicated by the shrinking capital market activity. The continued decline in private sector debt growth may pose challenges for the U.S. economy, at least not representing the normal functioning of the U.S. economy.

Escalating Trade Frictions Increase Uncertainty

Morgan Stanley expects that Trump's tariffs and their further expansion (expected to be announced on April 2, the so-called "Liberation Day") may undermine confidence in the corporate sector. The information released around April 2 may reduce the uncertainty associated with the announcement itself, but it may also increase uncertainty regarding how trade partners and other economic entities will respond.

This will keep investors and business operators on edge. Factors such as trade tensions and geopolitical risks have increased the demand for safe-haven assets. U.S. Treasuries, as one of the safest assets globally, naturally become the preferred choice for investors.

As previously mentioned, during a significant pullback in U.S. stocks, investors flocked to U.S. Treasuries for safety, with inflows into U.S. bond funds reaching $90 billion in February, approaching the $126 billion inflow into stock funds Especially for "ultra-short-term" government bond funds, this year, the inflow of funds into ultra-short-term bond ETFs accounted for over 40% of the total inflow into fixed-income ETFs. The significant inflow of risk-averse funds will also support U.S. Treasuries.

The Federal Reserve is in a rate-cutting cycle, and U.S. Treasury yields are expected to decline further

Morgan Stanley stated that as the risks of economic downturn increase, the current market pricing of Federal Reserve policy should encourage more investors to purchase U.S. Treasuries. The market-implied low point for policy rates is still well above the longer-term neutral rate recorded by Federal Reserve Committee members.

Morgan Stanley believes that the likelihood of the Federal Reserve lowering the policy rate to 3.0% by 2026 is increasing, consistent with its baseline forecast for the U.S. economy, which indicates that the policy rate will be below 3.0% next year. As the market re-prices to a lower policy rate low point, U.S. Treasury yields should decline further:

• The 10-year U.S. Treasury yield should fall below 4.0%; if the market prices the Federal Reserve returning to 3.0%, it could drop to as low as 3.85%.
• If the 10-year U.S. Treasury performs more strongly relative to the historical relationship with Federal Reserve policy pricing, the 10-year U.S. Treasury yield could even reach 3.75%.

As of the time of publication, the 10-year U.S. Treasury yield was reported at 4.299%, down more than 50 basis points from this year's peak.