To Hike or Not to Hike

Matthew Hornbach · Morgan Stanley

Ten-year yield's last 25bp rise to 5.25% was technical flows; yields have since settled near fair value.

The main driver of the Treasury sell-off since March was energy prices, both abroad and domestically. Those prices pushed the Fed from easing in 2025 to tightening in 2026 and into 2027, and the bond market repriced that shift. The last 25bp of the rise, from about 5% to 5.25%, was mostly technical. Flows in a very large fixed income market, including agency mortgage-backed securities and the corporate bond market, pushed yields to their peak. Once those flows stopped, yields settled at a level more consistent with fair value given the Fed's expected path.

“we think was driven much more by technical flows related to a very large fixed income marketplace that includes more than just US treasury securities... once those technical flows stopped, then we saw yields settle back down to a level that was more aligned with fair value”at 8:41

Matthew Hornbach · Morgan Stanley

Ten-year yields should fall in 2027 if the Fed reverses hikes as disinflation resumes.

Treasury yields are moving with how investors read the Fed's policy path. Once the Fed delivers the expected hikes, investors will judge whether it holds rates where they are. If disinflation resumes, the Fed might even reverse some of those hikes. In that case, Hornbach expects ten-year yields to fall in line with the lower expected policy path. Through 2027, the bond market will likely keep moving with the Fed narrative as inflation, the labor market and the Treasury market are watched ahead of the early-December FOMC meeting.

“And as the disinflationary process resumes, [the Fed] might even consider reversing some of these rate hikes that they have put into place, I would expect ten year treasury yields to fall alongside of those expectations for monetary policy.”at 9:59

Michael Gapen · Morgan Stanley

US economy isn't overheating: labor market loose and wage growth decelerating despite AI investment.

Growth is resilient and inflation is sticky, but the labor market doesn't look like it is overheating. Job gains are only about 50,000 a month. The unemployment rate is low, but wage growth is decelerating. Gapen argues there is little evidence that the broader economy is overheating even with the AI investment boom. Because the Fed isn't behind the curve, it doesn't need to tighten aggressively, which supports a measured recalibration rather than a more aggressive hiking cycle.

“We're only adding about 50,000 jobs a month. The unemployment rate is low. That's true. But wage growth is actually decelerating.”at 3:06

Matthew Hornbach · Morgan Stanley

Early-year inflation prints run hot and late-year cool from residual seasonality; may recur in 2027.

The Bureau of Labor Statistics and the Bureau of Economic Analysis have had trouble seasonally adjusting inflation data. Over the past couple of decades, seasonally adjusted inflation has typically come in much stronger in the first month or two of the year and lower in the final couple of months. This pattern is what Hornbach calls residual seasonality. It could recur in 2027 and show inflation picking back up, which would matter for how the Fed responds. He hedges that it may not happen.

“in the first month or two of the year, you typically have seen the seasonally adjusted inflation data come in much stronger... And then in the final couple of months of the year, you've tended to see inflation data come in lower”at 5:20

Michael Gapen · Morgan Stanley

Fed delivers one more rate hike in March, then stops once inflation is clearly decelerating.

Residual seasonality is still in the data: many firms raise prices once a year, mostly in January and February, and the seasonal adjustment process doesn't capture this. That makes it harder for the Fed to read the underlying inflation trend, so it needs more data before deciding. Gapen's view is that this means one more hike in March. After that, it only becomes clear that inflation is decelerating and the Fed stops hiking. He adds that the labor market isn't overheating, so there is no urgency to hike at every meeting. Firming inflation could shift the Fed to hiking every meeting, and a broad-based labor market turnaround could bring more hikes in 2027.

“So in our view, it actually means you still get one additional rate hike in March. Then after that, it only starts to become clear that inflation is decelerating and the Fed stops hiking.”at 6:40