Morgan Stanley: US growth remains strong, but funding costs are near the peak of the last tightening cycle

Why are risk assets under pressure when economic growth is not weak?

US real GDP grew 2.1% year over year over the past year, and the annualized growth rate over the latest two quarters was 2.8%. Morgan Stanley's equity strategy team also observed slowing earnings growth, followed by a rapid tightening of monetary conditions.
Over the past four quarters, domestic private final demand added an average of 2.8 percentage points to annualized real GDP growth; after accounting for the drag from net exports, the contribution fell to 1.6 percentage points. The bank notes that AI-related fixed investment also comes with imports, so its contribution to growth cannot be considered in isolation.
The bank believes that in the middle of an economic cycle, a rapid rise in funding costs can hurt economically sensitive sectors and broaden an existing stock market correction, even if growth remains positive.

The federal funds proxy rate that Morgan Stanley uses to measure overall monetary conditions is about 4.93%, compared with an actual effective federal funds rate of 3.88%, a gap of about 105 basis points. The proxy rate is approaching the peak policy rate of the 2022–2023 rate-hiking cycle.
The bank notes that, outside periods such as the financial crisis and the pandemic recession, the gap between the two is generally within plus or minus 100 basis points. The current gap mainly reflects a broad rise in bond market yields; it could narrow if the Federal Reserve continues raising rates or if Treasury and corporate bond yields fall.

The rise in funding costs stems from both higher Treasury yields and wider spreads between AI-related investment-grade corporate bonds and Treasuries. Over the past year, yields on investment-grade bonds related to AI data centers rose 100 basis points more than Treasury yields; yields on AI hardware-related bonds rose 50 basis points more than Treasury yields over the past five-plus months.
Morgan Stanley believes the recent widening of corporate bond spreads may have more to do with risk aversion than supply. In the 21 trading days through 21 October, total investment-grade corporate bond issuance, measured on a 10-year Treasury equivalent basis, was 82 billion US dollars, matching the lowest level for any 21-day window that year; primary dealers' holdings of longer-dated investment-grade corporate bonds were also below their August peak.

Morgan Stanley believes the midterm elections affect interest rate markets primarily through the stock market. If risk aversion persists, Treasury yields could fall further, while the shape of the yield curve could fluctuate irregularly ahead of the nonfarm payrolls and CPI releases; both will be published within a week after the 3 November vote.
Ahead of the election results and the next round of data, the bank recommends holding off on adding duration or yield curve risk while maintaining its existing SFRZ6Z7 curve-flattening trade: the reference level is 35 basis points, the target is 10 basis points and the trailing stop is 53 basis points. The main risks to the trade include stronger-than-expected economic activity or a market perception that the neutral rate is rising.