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One of the biggest debates for the year ahead is around interest rates, and specifically, how much they’ll rise. Economists at Morgan Stanley think the yield on the benchmark US 10-year government bond will rise by about 0.5%, to a yield of about 1.5%. That’s more than what the market and many investors expect.

Key quotes

“Some investors aren’t as optimistic as we are about the US or global economy next year, and since yields and economic activity tend to rise and fall together, this is a natural place for honest disagreement. But there’s another, different type of skepticism towards higher interest rates. This camp agrees that growth will improve next year, but they don’t think that yields will rise as much as we expect, because the Federal Reserve wouldn’t allow that to happen.” 

“The idea that the Fed would prevent a rise in interest rates is pretty common in the market. But we think it’s wrong. Not wrong, we’d stress, because it assumes the Federal Reserve would prefer interest rates to be low – we think they do – but wrong because it would imply a pretty material leap in action, a leap that’s both risky and potentially unnecessary.” 

“Interest rates are so low that even if they were to rise the 0.5% that we forecast next year, they’d still be some of the lowest levels ever recorded, both outright, and relative to the levels of inflation.”

“One of the most powerful channels for low-interest rates to help the economy is via mortgages. But due to some quirks in the housing market, it’s been hard for mortgage rates to fully follow bond yields on their move lower this year. And since mortgage rates have lagged on the way down, they might also lag on the way up.”

“We think interest rates will rise next year, supporting an underweight in bonds and an overweight in financial equities. Part of that view is based on an optimistic assumption for global growth. But another important part of the story is around expectations for central banks and what they will, and perhaps won’t do.”