Morgan Stanley IM: An Early Holiday Present

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By October 24, U.S. Treasury 10-year yields were making a new historical high around 4.24%, up 43 basis points(bps) from the end of September. Fast forward to the end of November and things look a lot different. U.S. Treasury 10-year yields ended the month at 3.61%, down a whopping 61 bps lower from their October peak. Real yields joined the party as well with U.S. 10-year real yields down approximately 20 bps over the month, about 50 bps down from their intra-month high. What gives?

First, it wasn’t just the U.S. bond market that rallied. It was truly a global phenomenon. Outside of Japan and a few Emerging Market (EM) countries, 10-year yields fell anywhere from 23 bps in Australia to 185 bps in Hungary. Second, not only did risk-free yields fall, but credit spreads narrowed as well, significantly so in Euro denominated bonds. Third, the U.S. dollar fell significantly. The Japanese yen, for example, rose over 8% versus the dollar from its October low, not coincidentally corresponding almost to the day U.S. Treasury yields peaked. November fixed income total returns measured in U.S. dollars or local currency were truly staggering.

The key to the rally was threefold. Two of which were not so surprising, with the third more so. In October several central banks made it clear they were uncomfortable with raising rates further or uncomfortable with the size of rate hikes. Eastern European central banks were in the vanguard of this movement, but they were joined by the central banks of Sweden, Norway, Australia and Canada. Notably missing from this list was the Fed, who in October took seemingly the opposite stance. The first November surprise was a better-than-expected U.S. inflation report. After many months of disappointment on this front the market embraced this one data point as evidence that inflation had now peaked and was on its way down. Secondly, the U.S. inflation surprise could not have been better timed relative to market positioning. After the surge in yields over October, bond markets were ripe for a correction or at a minimum bear market rally/squeeze. Lastly, the coup de grace so to speak, was the apparent toning down of Fed hawkishness, with more FOMC members vocalizing their belief that enough had been done, at least for now. While in many ways this wasn’t surprising, at some point, the Fed had to start to acknowledge that it had raised rates a lot and needed to slow down/pause to assess its impact. And off to the races we went.

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^{Risk Considerations}

^{Diversification does not eliminate risk of loss. There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks. Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities (“junk bonds”) are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).}