However, it cautioned that despite the positive outlook, challenges and uncertainties may persist, indicating that the journey ahead for emerging markets may not be without obstacles.
After three weeks of client meetings, the brokerage has identified ten potential surprises, whether positive or negative, that could significantly impact the global markets in 2024. However, one must note that these surprises pose the risk of introducing unexpected developments that may have far-reaching effects on various financial landscapes, warned the brokerage.
Let’s take a look at these 10 surprises:
Surprise 1: The elusive US hard landing arrives in style
In 2023, the most significant surprise was not the avoidance of a US hard landing but the unexpected absence of a soft landing as well. Contrary to expectations, the economy neither landed nor found the soft landing strip, which was perceived as a mirage in the end, stated MS.
According to the brokerage, the concept of a soft landing had been viewed with skepticism by investors, resembling a belief in “this time is different,” considered four of the riskiest words in finance. Despite the lack of substantial evidence supporting the soft landing narrative, it gained consensus for the year ahead.
Looking forward to 2024, the potential major surprise could be the arrival of the elusive hard landing, catching most investors off guard just after they concluded that “this time was indeed different.” While it took the better part of the previous year for the consensus to fully embrace the soft landing narrative, the reversal to a hard landing may happen more swiftly, leading investors to regret being misled once again, predicted the brokerage.
Surprise 2: Fed cuts 8 times, amid soft landing
In 2024, the much-anticipated “soft landing” materialises, characterised by stable core Personal Consumption Expenditures (PCE) at around 2% and moderate economic growth, aligning with projections from its US economics team. Despite the Federal Reserve signaling a possibility of rate cuts at the December FOMC meeting, the central bank surprises by delivering a total of eight cuts throughout the year—significantly surpassing both the latest dot plot’s projection (3 cuts) and market expectations of around 6 cuts in 2024, forecasted MS.
While the conventional market reaction to eight cuts would theoretically be a bull steepening of the yield curve, an additional surprise unfolds in 2024 as the yield curve bull flattens instead. This unexpected development may stem from factors such as the high consensus around curve steepeners, real money investors quickly covering duration underweights by extending positions in the very long end, and a yield grab from retail investors. Despite six cuts being priced in, the carry-on on the front end proves punitive for overall returns, making the long end more attractive.
Moreover, the market is expected to witness renewed demand from various quarters in 2024, including US banks, overseas official buyers, households, and hedge funds, as macroeconomic factors drive buyer interest, said the brokerage.
Surprise 3: QT ends before the first cut
Another surprise, as MS predicts, is that – in the first half of 2024, unforeseen challenges materialise, prompting the Federal Reserve to abandon its plans for balance sheet reduction before the anticipated rate cut in June. While the brokerage’s base case suggests the Fed will taper Quantitative Tightening (QT) in September, with the balance sheet ceasing to decline in early 2025, notable tail risks emerge earlier than expected, creating concerns for funding conditions and market functioning, it predicted.
Three distinct tail risks come to the forefront, surprising not only the Fed but also investors and forecast. Firstly, the responsiveness of the Reverse Repurchase Agreement (RRP) to higher repo rates keeps SOFR (Secured Overnight Financing Rate) on a gradual upward trajectory. However, disruptions in the ability of dealers to intermediate the repo market emerge in mid-1Q24 and onwards, impacting the RRP’s effectiveness in meeting surges in demand for financing.
Secondly, in 1H24, the structural demand for bank reserves intensifies as banks continue to lose non-interest-bearing deposits. This prompts banks to retain more liquidity, potentially keeping reserves at a higher level closer to the current $3.5 trillion, depleting the RRP sooner than the base case projection.
Thirdly, a threat to the Fed’s QT plans extends beyond the repo market. The Federal Reserve faces challenges justifying the extension of the BTFP (Bank Term Funding Program), created under Section 13(3) of the Federal Reserve Act as an emergency lending program, after March. Mounting bank liquidity pressures lead to a new round of stress in 2Q24, indicated by a record increase of $14 billion in the BTFP over the past 6 weeks, setting a new high of $126 billion. These unexpected developments pose substantial risks to funding rates, the proper functioning of the repo market, and the effective implementation of monetary policy from the third quarter of 2024 onward.
Surprise 4: Europe’s outlook less bleak than anticipated
The prevailing market narrative suggests that Europe is on the brink of a significant growth slowdown. Based on this premise, the general expectation is that the periphery may underperform, particularly in the initial stages of a recession, as credit is anticipated to trade at a substantial discount relative to duration. This expectation is further fueled by factors such as high-yield pressures due to heavy issuance expectations and the ongoing process of ECB balance sheet normalisation, contributing to the anticipated widening thesis.
However, the validity of this assumption is questioned if the European Central Bank (ECB) successfully achieves a soft landing. Recent shifts in market pricing at the front end indicate a faster re-convergence towards the neutral rate, now expected to be realized by June 2025 at the latest. Additionally, leading economic indicators have consistently outperformed hard data releases since the summer. These emerging trends prompt a reconsideration of the market’s earlier assumptions regarding the European economic landscape, suggesting that the initial expectations of a growth slowdown may be reassessed in light of evolving economic indicators and market dynamics, said the brokerage.
Given the current mix of factors, the outlook suggests a growth perspective that is potentially less bleak than initially anticipated. As the European Central Bank (ECB) adopts an easing stance, the potential challenges posed by higher yields, coupled with a scenario where growth doesn’t see a substantial decline, indicate that the market may find support for risk, it predicted.
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Surprise 5: EUR 10s30s bull flattens amid a hard landing
Throughout 2023, and with the anticipated commencement of an easing cycle by the European Central Bank (ECB) in the coming year, one of the most widely agreed-upon trades has been, and is likely to persist as, EUR 10s30s steepeners. This trade is deemed attractive from several perspectives – (i) a macro perspective, with no major economic shock on the horizon and central banks set to start normalising monetary policy, (ii) a valuation perspective, as 10s30s remains historically markedly inverted and flags as 14bp flat on its model and (iii) historical analysis suggests 10s30s tends to steepen during ECB plateaux.
“However, this scenario is highly dependent on the absence of a hard landing or a risk-off event, particularly given that a return of the European Central Bank (ECB) deposit rate to 2% is already factored into market expectations. To gauge the potential impact of a sharp deterioration in the macroeconomic outlook on EUR 10s30s (vs. 6m), the brokerage have assessed stress scenarios using variables in our model,” it said.
Furthermore, recent developments such as historically low equity volatility, and the positioning in 10s30s steepeners heighten the risk of a bull-flattening scenario for EUR 10s30s in the event of a hard landing. This is the perspective, acknowledging that market dynamics and risk exposures may evolve in response to changing economic conditions, it added.
One must note: “EUR 10s30s” refers to the yield spread between 10-year and 30-year Eurozone government bonds. This spread is calculated by taking the difference between the yields on 10-year bonds and 30-year bonds issued by Eurozone countries. A “steepener” in this context refers to a trade or strategy where investors expect the yield curve to steepen, meaning that the spread between longer-term and shorter-term yields is expected to increase.
Surprise 6: An earlier-than-expected BoE pivot
In the recent sessions, the market has revised its expectations for Bank of England (BoE) easing higher, influenced by data indicating softer-than-expected wage growth and economic activity. However, despite this adjustment, the BoE is still perceived as a potential laggard in easing when compared to the European Central Bank (ECB) and the Federal Reserve. The market is pricing in fewer interest rate cuts for 2024 and a later commencement of the easing cycle by the BoE.
Following a notable rally in duration over the past week, the current market consensus suggests that the BoE could implement approximately 110 basis points of cuts throughout 2024. Moreover, a full 25 basis point cut is almost priced in for May 2024, indicating the market’s anticipation of monetary policy adjustments by the BoE in the coming months.
Although this consensus view is supported by various factors, there is a potential underestimation by investors of the recent momentum in inflation and economic data. Additionally, the delayed impact of previous monetary policy tightening might act as a catalyst for a BoE pivot earlier than initially anticipated. This suggests that market dynamics and economic conditions could prompt a shift in the BoE’s stance sooner than the prevailing consensus suggests, noted the brokerage.
Surprise 7: The JGB curve steepens instead of flattens
As many international investors anticipate a terminal interest rate in the 0.5%–1.0% range for the Bank of Japan’s (BoJ) seemingly imminent hiking cycle, there is a prevailing consensus that the yield curve will eventually flatten, particularly through the super-long sector, attributed to the underperformance of the belly zone. It would be somewhat unexpected if the curve were to continue steepening even after the BoJ initiates its “normalisation” process.
There exists a risk for the curve to either bear-steepen or twist-steepen if the BoJ signals a gradual approach to normalisation, but domestic investors, particularly life insurers, and others, remain unexpectedly hesitant to “buy the dip” in the long-end of the yield curve. Furthermore, maintaining flattener positions could prove to be expensive due to negative carry, especially if short- to medium-term yields fail to rise as much as currently anticipated in the near to medium term. This dynamic adds a layer of uncertainty to the future trajectory of the Japanese yield curve, said MS.
Surprise 8: Window for GBP gains
The British Pound (GBP) emerged as the second-best-performing currency in the G10 basket this year, narrowly trailing behind the Swiss Franc (CHF). The notable strength of the GBP can be attributed primarily to the unexpected resilience of core inflation in the UK. This resilience translated into a bank rate that exceeded expectations, making the GBP particularly appealing in a market that places significant emphasis on carry.
Despite MS’ base case suggesting that the GBP’s advantage could be eroded by lower-than-expected economic data and bond yields, there remains a potential for the GBP to continue surprising a predominantly bearish investor community.
While its stance is more bearish than the consensus on both UK data and UK bond yields, this view is not unique. Consensus projections indicate that UK growth in 2024 is anticipated to be the second lowest among G10 countries, surpassed only by Sweden.
Given the currently low expectations, the potential for positive surprises increases. The most favorable scenario for the British Pound (GBP) would involve positive growth surprises combined with negative inflation surprises. This is because disinflationary pressures could provide leeway for the BoE to implement more aggressive rate cuts, further enhancing growth expectations already boosted by positive surprises in economic growth. A twist steepening in the UK yield curve resulting from this combination is likely to have a positive impact on the GBP.
Surprise 9: Drop in Australia and Canada market pricing
Currently, market pricing suggests an expectation that medium-term interest rates will be notably higher than recent averages. However, there is a potential for a surprise in which medium-term rate expectations could decline to levels near or even below recent averages, particularly in Australia and Canada. Two primary reasons support the view that markets might be underpricing the likelihood of lower longer-term rates in these countries:
Sluggish Productivity Growth: Both Australia and Canada have experienced sluggish productivity growth, which could weigh on their respective economies and contribute to lower medium-term rates.
Potential Decline in Chinese Trend Growth: There is a possibility that Chinese trend growth may decline significantly, and this could have implications for the terms of trade in both Australia and Canada.
While arguments exist for the possibility of structurally higher rates, driven by shifts toward a more fragmented and multipolar world, domestic factors in Australia and Canada might lead to a decline in medium-term rate expectations in 2024. The downside risks to medium-term policy rate expectations have received less attention, with central bankers focusing more on the upside risks to long-term interest rates. If medium-term rates in the dollar bloc (Australia and Canada) were to decline in 2024 below their 10-year averages, it would likely be viewed as a surprise.
Surprise 10: Breakevens revert to 2019 levels
In the US, inflation markets are indicating a return to pricing breakevens at pre-pandemic levels by the end of 2024. This shift is attributed to investors interpreting the recent inflationary experiences as driven by supply-chain disruptions and fiscal shocks. Additionally, the tightening actions by the Federal Reserve, currently in progress, are expected to result in downward surprises to the Consumer Price Index (CPI) over the course of 2024.
As a consequence of these expectations, inflation risk premiums become significantly negative, leading to a tightening of breakevens. The market anticipates a drop of approximately 30-50 basis points from current levels by the end of 2024, with the most significant adjustments occurring for front-end points. This adjustment is driven by the anticipation of downside surprises in core inflation over 2024, prompting the market to reduce near-term inflation risk premiums.
Disclaimer: The views and recommendations made above are those of individual analysts or broking companies, and not of Mint. We advise investors to check with certified experts before taking any investment decision.
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Published: 18 Dec 2023, 02:42 PM IST