Open your eyes to this one major factor that will crush bond yields, says Morgan Stanley

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The only thing more favorable than the stock market on Monday were the refs’ calls for the Knicks, as a nice broad-based rally moved the S&P 500 SPX above its 50-day moving average for the first time since April 12.

Key to the rally have emerging signs of the U.S. economy slowing down, most notably shown in the 175,000 growth in payrolls in April. And while the yield on the 10-year Treasury BX:TMUBMUSD10Y has dropped about 20 basis points over the last four sessions, fixed-income strategists at Morgan Stanley say there’s a looming factor that should “open investor eyes into year-end.”

That factor? Residual seasonality. That is, the notion the seasonal adjustments from U.S. government statisticians aren’t being done properly, in a way that moves first-quarter numbers higher and rest of the year numbers down.

Residual seasonality isn’t a new thing, but what was a small observed factor from 2010 to 2019 has emerged as a giant one now.

To quantify the impact, Morgan Stanley employs a technique comparing the average annualized numbers for a quarter to the four-quarter average. For the preceding last two years, core PCE prices — the inflation numbers that mean the most to the Fed — have seen a giant 1.32 percentage point boost to first-quarter numbers that erodes as the year goes along.

This residual seasonality has shown up elsewhere, too — in the employment cost index series as well as unit labor cost data in the productivity numbers. “When so many price metrics display residual seasonality and show a similar pattern of it strengthening, investors would be forgiven for gaining confidence that the pattern will continue in the coming year,” say the strategists.

Translated into hard numbers, Morgan Stanley expects the three-month annualized rate of core PCE inflation to fall to 1.81% for the Dec. 2024 data released in January 2025, and the six-month annualized to fall to 1.96%.

What does this mean for markets? “Even if the economy doesn’t go down, bond yields could still fall dramatically as inflation data disappoint the higher-forever true believers,” they say. “Buy bonds.”

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