The Federal Reserve's interest rate cut window is approaching. Will U.S. Treasuries and the dollar face a critical turning point in the second half of the year?

Since the beginning of this year, global asset prices have been undergoing a significant adjustment: the yield on 10-year U.S. Treasury bonds has fallen more than 50 basis points from its high earlier this year, and the U.S. Dollar Index (DXY) has dropped over 10% from its peak. However, during the summer market, the downward momentum of these two major assets has encountered resistance.

Morgan Stanley, in its latest global macro strategy report "At the Edge of Hot Summer, At the Threshold of a Larger Fall," points out that as the window for the Federal Reserve's interest rate cuts gradually approaches, U.S. Treasury yields and the dollar index are expected to both hit new lows for the year this autumn, providing investors with a clear layout direction.

1. Macro Mainline: Federal Reserve Rate Cuts as the Core Driving Force, U.S. Treasury Yields May Fall Below 4%

The shift in Federal Reserve policy is the core logic for global asset pricing in the second half of the year.

At this year's Jackson Hole Global Central Bank Annual Meeting, Federal Reserve Chairman Jerome Powell released clear dovish signals, stating that "current policy is in a restrictive range, and the economic outlook and risk balance may require an adjustment in policy stance," directly pushing the market-implied low for the federal funds rate below 3% (currently at 2.94%).

Morgan Stanley notes that this rate low still has further room to decline: on one hand, the current level is higher than 2.87% in April 2025 and 2.69% in September 2024; on the other hand, Federal Reserve economists expect the final federal funds rate may drop to 2.625% (rather than the current market pricing of 3%), primarily due to the tightening of U.S. immigration policies, which will slow labor market growth, thereby lowering potential economic growth and the equilibrium interest rate (r*).

The correlation between U.S. Treasury yields and the federal funds rate will continue to dominate the bond market trend. Report data shows that after a brief divergence in April 2025, the two have resynchronized.

(Market-implied federal funds rate low and 10-year U.S. Treasury yield)

If the federal funds rate low falls below 2.69%, the 10-year U.S. Treasury yield is expected to drop below 4%.

(Market-implied federal funds rate low and fitted relationship with 10-year U.S. Treasury yield)

In addition, the expected improvement in the U.S. fiscal deficit also supports U.S. Treasuries. The latest forecast from the Congressional Budget Office (CBO) indicates that tariff adjustments from 2025 to 2035 will reduce the federal deficit by $4 trillion (higher than the $3 trillion forecast in June), which will lower the demand for Treasury issuance and further suppress long-term yields

(U.S. Federal Budget Deficit as a Percentage of GDP)

(Deficit Forecasts Under Different Scenarios)

II. Core Investment Strategy: Go Long on U.S. Treasury Duration, Go Short on the Dollar, Seize Two Major Opportunity Lines

Based on the above macro judgment, Morgan Stanley provides two core investment recommendations covering the U.S. Treasury and foreign exchange markets:

1. U.S. Treasuries: Go Long on Duration + Steepening Yield Curve, September May Welcome Accumulation Window

Go long on 5-year U.S. Treasury duration: The 5-year U.S. Treasury features "low volatility + high nominal yield" characteristics (current yield 3.75%). In a declining yield cycle, the duration strategy will directly benefit from price increases; at the same time, the 5-year U.S. Treasury is more sensitive to interest rate cut expectations than the long end, allowing it to capture policy shift dividends more quickly.

3-year / 30-year U.S. Treasury yield curve steepening: The short end (3-year) is directly driven by the Federal Reserve's interest rate cuts, with greater room for yield decline; the long end (30-year) is supported by economic outlook and deficit expectations, with relatively limited declines, and the spread between the two will continue to widen. The report suggests that if the U.S. Treasury index extends in September (expected to extend by 0.07 years, higher than the monthly average), leading to short-term flattening of the curve, it may be an opportunity to increase the steepening strategy (see Illustration 4: 10-year U.S. Treasury term premium reverts to residual, indicating that the current term premium is still at a low level, with no upward pressure).

In addition, the report warns to exit the short strategy on 10-year Treasury Inflation-Protected Securities (TIPS) — current inflation expectations have fallen in line with term premiums, with limited further downside and rising negative carry risks.

2. Foreign Exchange: Firmly Go Short on the Dollar, Euro and Yen as Top Choices

Morgan Stanley's bearish stance on the dollar is clear, recommending going long on the euro (EUR) and yen (JPY) to hedge against dollar downside risks, with three core logics:

Interest Rate Differentials Further Unfavorable to the Dollar: The Federal Reserve's rate cuts will far exceed those of the European Central Bank — ECB President Lagarde has clearly stated that "the current 2% interest rate is close to neutral, and the threshold for further rate cuts is high." Morgan Stanley has raised its 2025 forecast for the yield on 2-year German government bonds by 10 basis points; while the Bank of Japan is not raising rates for now, market expectations for a narrowing of the U.S.-Japan interest rate differential have risen, significantly increasing the sensitivity of the dollar/yen.

(Euro-American Federal Funds Rate Low Pricing Comparison)

(U.S. and Euro 2-Year Yield Spread and U.S. Dollar Index Forecast)

Negative Risk Premium of the Dollar May Widen: Since April, the U.S. dollar index has consistently been below the implied level of the yield spread, reflecting the market's pricing of uncertainty in U.S. policy (Federal Reserve independence, trade policy). Although this "negative premium" has narrowed from 7%-8% to 6% recently, the report suggests that the execution of the U.S.-EU trade agreement relies on EU legislation, tariffs remain a tool of U.S. foreign policy, and there are doubts about policy continuity after Powell's term ends; these factors will likely widen the negative premium again.

(U.S. Dollar Policy Premium Fitting)

(U.S. Dollar Policy Premium Trend)

Investor Positioning Structure Reversal: Current investors are no longer shorting the dollar (Morgan Stanley Dollar Positioning Index has returned to neutral, see below), which means the "short covering" pressure when the dollar declines has disappeared, opening up further downside potential.

In terms of specific strategies, the report recommends: maintaining long positions in Euro/USD (entry price 1.17, target 1.20, stop loss 1.11), short positions in Dollar/Yen (entry price 147.40, target 135, stop loss 151), and simultaneously going long on Pound/Swiss Franc (carry/volatility ratio ranks first among G10 currencies, entry price 1.084, target 1.12, stop loss 1.055).

III. Policy Dissection of Major Economies: Differences in Strategies of Eurozone, UK, and Japan

In addition to the global mainline, the report also provides differentiated strategies for major economies such as the Eurozone, UK, and Japan:

1. Eurozone: Focus on flattening the curve from October to December and opportunities for rollovers in September.

Interest Rate Strategy: It is recommended to enter into a flattening strategy for the Eurozone's October to December yield curve (with a baseline scenario of a rate cut by the ECB in December, short-end rates will decline faster), while tactically expanding the OE swap spread during the September government bond futures rollover period (historical data shows that short positions can push swap spreads wider during rollovers) Asset Allocation: The year-end target for Germany's 10-year government bond yield has been raised to 2.40% (previously 2.25%). Green bonds (FRTR 6/44) have significant allocation value due to yields being notably higher than the conventional curve.

1. United Kingdom: The Bank of England's interest rate hike cycle is coming to an end, going long on short-term rates.

The Bank of England passed a rate cut in August with a 5:4 vote, and the market has priced in a cumulative rate cut of 10 basis points by year-end. The report suggests: entering positions for the November Bank of England policy rate (MPC) (current pricing indicates a cumulative rate cut of 5 basis points in November, with a reasonable risk-reward ratio), while maintaining a steepening strategy for 3-year / 10-year UK bonds (increased supply of UK bonds in September puts pressure on the long end).

1. Japan: Buy 10-year Japanese bonds on dips, beware of yen fluctuations.

Bank of Japan Governor Kazuo Ueda did not mention "wage-price positive cycle" in his speech at Jackson Hole, indicating no immediate rate hike, but market expectations of a decline in U.S. Treasury yields have improved sentiment for Japanese bonds. The report suggests: maintaining long positions in 10-year Japanese bonds, and increasing positions if the breakeven inflation rate (BEI) significantly declines; the USD/JPY may be temporarily affected by U.S. non-farm data, but the long-term downtrend is clear.

IV. Risk Warning: Three Major Factors May Disrupt Asset Rhythm

Although Morgan Stanley has a clear judgment on asset trends for the second half of the year, it also warns of three major risks:

Federal Reserve rate cuts may fall short of expectations: If U.S. inflation remains sticky (e.g., energy prices rebound) and non-farm employment remains strong, it may delay the timing of rate cuts, leading to a temporary rebound in U.S. Treasury yields and the dollar;

Geopolitical shocks: If the situation in the Middle East or conflicts in Europe escalate, the dollar may strengthen in the short term due to safe-haven demand;

Major central bank policies may exceed expectations: For example, if the European Central Bank shifts to a more dovish stance due to an accelerating economic recession, or if the Bank of Japan raises rates earlier, it may reverse the trends of the euro and yen.

Summary: Asset Allocation Logic Under the Rate Cut Cycle

Morgan Stanley believes that in the second half of 2025, global assets will revolve around the main theme of "Federal Reserve rate cuts," with the core trends being the decline in U.S. Treasury yields and the weakening of the dollar. Investors can focus on two major directions: first, capturing bond market dividends through 5-year U.S. Treasury bonds and a 3s30s steepening strategy; second, seizing opportunities in non-U.S. currencies through long positions in euros and yen. At the same time, it is essential to closely monitor the September Federal Reserve meeting, U.S. non-farm and inflation data, as well as the implementation pace of major economies' policies, and adjust positions in response to short-term fluctuations