Is the expectation of raising interest rates wrong? The Morgan Stanley: market is expected to eventually compromise with the Federal Reserve.

Over the past six to eight weeks, the overall performance of risk assets has been lacklustre: the S & P 500 has consolidated at high levels, technology stocks have fallen across the board, and US investment-grade credit spreads have remained within a narrow range of about 90 basis points. At the same time, the US bond market has been suffering a steady sell-off, with the yield on the benchmark 10-year Treasury note climbing about 60 basis points over the same period.

The reason behind the market trend is largely due to the expectation of higher interest rates in the market. Generally speaking, with stronger-than-expected economic growth and a sharp fall in overall unemployment, the traditional monetary policy response will be tightened by rising inflation expectations.

In fact, the current pricing in the bond market reflects that the Fed will raise interest rates once (25 basis points) in early 2023 and twice more by the end of 2023. The logic behind the bond market bet is that trillions of dollars of stimulus packages and accelerated vaccination campaigns mean that front-end interest rates cannot be kept so low, or inflation will spiral out of control.

Interestingly, however, the Fed does not think so at the moment. In the interest rate bitmap forecast released at the interest rate meeting this month, only seven of the 18 Fed officials predicted that interest rates would rise by the end of 2023, and only a smaller number (four) predicted that the Fed would act in 2022. The median forecast remains that the Fed will keep current interest rates unchanged until 2023.

Fed officials also stressed that while the median for FOMC officials is that core inflation will remain at or above 2 per cent until 2023, this alone is no reason to consider raising interest rates, as maximising employment in the labour market remains the Fed's top priority. Not only has the Fed raised the threshold for future interest rate hikes, FED Chairman Powell has also been dovish on the issue of reducing the size of asset purchases, making it clear that they will be guided by actual data rather than forecasts.

Clearly, the expectations of an interest rate hike reflected in the bond market are in sharp contrast to the signal from the Fed. So next, will the market compromise with the Fed? Or will the Fed turn to the market and bow its head?

Matthew Hornbach and Guneet Dhingra, global macro strategists at, Morgan Stanley, believe that the former situation is more likely this time. Strategists advise investors to treat recent technology-driven price movements as noise and focus on signals from the Fed.

Dhingra said it was understandable that there was some disconnect between the market and Fed policy, but the extent of the disconnect was exaggerated. The market is generally looking forward, but the Fed's new framework is designed to look backward. In the end, it is more likely that the market will yield to the Fed than the Fed to the market.

Economists at Morgan Stanley predict that the Fed will not be in a position to raise interest rates until the third quarter of 2023, while balance sheet reduction will begin in January 2022.

They say the Fed's action step is expected to be to reduce bond purchases and then raise interest rates, as it finally did after the 2008 financial crisis, which means there is still a long way to go to raise interest rates.

Morgan Stanley recommends overmatching the belly of the Treasury yield curve and expects the 5-year / 30-year yield curve to steepen further as tightening expectations diminish. At one point this month, the spread rose to about 166 basis points, close to its widest level since 2014, before falling back to about 150 basis points.

The Morgan Stanley strategy team also cautioned, "clearly, in terms of policy, we are in uncharted territory. The Fed's policy response could mean that the current economic cycle is likely to be hotter than the previous three, but for a shorter time. The dominant position of risk assets has shifted from 'early cycle' to 'mid-cycle', and investors should adjust their positions accordingly. "