The Tell: What pandemic? Early innings of recovery may already be over, says Morgan Stanley

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Is the early innings of this economic cycle already over?

Such thoughts can appear premature with the global economy still grappling with a worldwide pandemic, but analysts at Morgan Stanley warns because the current cycle is likely to “run hotter and shorter” thanks to easy fiscal and monetary policy, investors should start shifting out of assets that perform their best after growth is starting to pick up after a recession.

“A rapid economic recovery and an emergence of inflation after a 30-year
absence mean this cycle could be shorter than the prior 3, in our view,” Morgan Stanley said in a Tuesday note, warning the market was already transitioning into what it dubbed the mid-cycle “recovery” phase.


Morgan Stanley

So how should investors position for the transition?

The Wall Street bank advised investors to buy shorter-dated bonds, lower-rated corporate debt, and equities outside of emerging markets.

In addition, analysts said traders should get ready to ditch yield-curve steepeners, one of the most popular bond-market investment strategies this year, and start betting on the yield curve to flatten. In a steepener trade, a market participant will buy short-dated Treasurys and short their long-dated peers to profit from a widening spread between the two maturities, or a steeper yield curve.

The spread between the 2-year Treasury note
TMUBMUSD02Y,
0.145%

and the 10-year note
TMUBMUSD10Y,
1.610%

was at 1.47 percentage points, around its widest since mid-2015.

The idea behind a curve flattener was to prepare for the Federal Reserve to start shifting toward a less accommodative stance earlier than the central bank has been prepared to signal. In the end, the yield curve would invert altogether as investors saw the central bank ready itself to hike rates sharply to curb inflationary pressures.

This is despite the central bank indicating it had yet to even start discussing about what conditions were necessary before the Fed to taper asset purchases, a prelude to a rate hike.

“A shorter cycle — driven by Fed policy that eventually reacts aggressively to the hotter cycle — should cause the yield curve to flatten equally as aggressively,” they said.

In markets on Tuesday, the S&P 500
SPX,
-0.16%

and Dow Jones Industrial Average
DJIA,
-0.37%

were trading lower, retreating from record highs. The 10-year Treasury note yield
TMUBMUSD10Y,
1.610%

was at 1.625%.

See: What would cause the Fed to take a U-turn? Hint: a lot more than some high inflation readings

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