(Bloomberg) -- Investors in US government bonds are starting to bet the Federal Reserve will soon need to pivot from worrying about sticky inflation to fretting about slowing economic growth.
That sentiment helped drive Treasuries to gain for a sixth straight session, which has pushed yields to their lowest levels of the year. Meanwhile, strategists at Morgan Stanley say the 10-year has scope to fall back below 4% if the prevailing view on the Fed shifts somewhat.
Traders this week resumed fully pricing in two quarter-point cuts by the Fed this year, and most of a third one next year, to a level of about 3.65%. Morgan Stanley says if the market prices in a drop to 3.25%, the 10-year can breach 4%. The bank expects inflation data to be released Friday — the prices indexes for January personal consumption expenditures, or PCE — to show a decline in the pace of price growth that could be decisive.
If central bank "rhetoric grows more dovish as a result of better core PCE inflation data, we think that investors will buy more duration – allowing market-implied trough rates to fall further," Morgan Stanley strategists led by Matthew Hornbach said in a note.
All three of this week's fixed-rate Treasury auctions drew strong demand, concluding with Wednesday's seven-year note sale. The $44 billion auction drew 4.194%, lower than its 4.203% yield in pre-auction trading close to the bidding deadline, a sign that demand exceeded dealers' expectations. Auctions of two- and five-year notes earlier this week produced similar results.
What Bloomberg's Strategists Say...
"A trade below 4.25%, the next logical and psychological yield support, looks unlikely in the absence of additional fundamental inputs, such as Friday's PCE data. That said, risk is a breach of 4.25% sparks investor fear of missing out on the rally."
— Alyce Andres, macro strategist
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The 10-year yield dipped Wednesday to as low as 4.25%. It spent several months below 4% during the second half of last year after notably weak July employment data set the Fed on course to cut rates by a percentage point by year-end.
Then, progress toward lower inflation stalled and the Fed paused in January, saying another rate cut could make things worse. Now, investors see not only in economic growth indicators but also in US fiscal and immigration policies a case for lower yields. Among them are the tariffs US President Donald Trump has been threatening to impose on major trading partners, a strategy that hurt the economy during his first term, alarming Fed policymakers.
"Already forceful changes to immigration policy could pull short-run GDP growth below potential next year," Hornbach wrote. "Increased investor attention on immigration trends should bring down still-elevated neutral rate expectations."
On Wednesday, Trump gave a series of apparently contradictory answers about his plans to enact tariffs on Canada and Mexico, as well as the European Union. A Bloomberg gauge of the dollar edged higher.
"The US economy carries solid momentum," but "increased uncertainty surrounding trade, fiscal and regulatory policy is casting a shadow over the outlook," said Gregory Daco, chief economists at EY. This "could lead to financial market volatility as well as businesses and consumers increasingly adopting a wait-and-see approach."
A new Federal Reserve Bank of Philadelphia survey found that almost one-third of US workers are concerned about getting laid off by their employers.
A steep drop in a gauge of consumer confidence on Tuesday was merely the latest sign that the US economy is faltering. A Citigroup Inc. index of US economic surprises declined fell to the lowest level since September, indicating that data isn't measuring up to expectations.
Federal spending cuts being sought by firing government workers since President Trump took office last month may also allow rate expectations to decline, Morgan Stanley says.
At the same time, the administration and its allies in Congress are pursuing deep tax cuts that could widen the US budget deficit, requiring additional borrowing. A budget blueprint passed by House Republicans last night calls for deep spending cuts as an offset.
"Bonds are responding to the potential of lower supply," Jim Bianco, president and macro strategist at Bianco Research, said on Bloomberg Television. "Now whether that happens, that's for later this year. And whether that's stimulative or inflationary, that's for later this year."
As for inflation, the growth rate for the PCE price index excluding food and energy has been about 2.8% for three straight months. Morgan Stanley's economists, who predict a Fed rate cut in June, expect it will fall to 2.58% for January.
--With assistance from Molly Smith and Alex Tanzi.
(Updates pricing throughout and adds latest tariff comments.)
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