As the year 2024 comes to a close, analysts from Morgan Stanley, led by Matthew Hornbach and Andrew MWatrous, have unveiled insights into the potential surprises that could shape global capital markets in the upcoming yearTheir report, released on December 20, outlines various scenarios that may impact not only the U.Seconomy but also European financial dynamics.

One of the key predictions relates to the U.Sfiscal deficit, which could be less aggressive than previously anticipatedIn contrast, Germany is projected to increase its fiscal spending, leading to a convergence of interest rates between the U.Sand EuropeThis scenario may contribute to a significant devaluation of the dollar, with the dollar index expected to settle around 101 by the end of 2025, facing notable downward risks.

Furthermore, the report indicates a stronger-than-expected demand for U.Streasury bonds in 2025. This anticipated surge in demand is primarily driven by banks, foreign investors, and pension funds, keeping long-term bond yields at relatively low levels.

Despite the general pessimism surrounding the euro's trajectory, Morgan Stanley posits that, against a backdrop of more substantial interest rate cuts than anticipated, coupled with milder trade shocks, the euro may defy expectations and even thrive

The interplay of these factors suggests a more complex landscape for currency valuations than many investors are willing to consider.

A deeper dive into U.Sfiscal policies reveals that the nominee for the next Treasury Secretary, Ben Bernanke, has suggested that prioritizing the reduction of the deficit as a percentage of GDP to 3% is crucialWhile many believe that achieving this target within the next presidential term may be challenging, Morgan Stanley hints at potential progress by 2025.

The analysis highlights that a shift towards a more conservative fiscal policy in the U.Scould contribute to lower treasury yields than currently expectedIn this context, the U.Sdollar is poised for a downward trajectory, exacerbated by the changing fiscal landscape.

On the German front, analysts anticipate that the establishment of a new government, expected by February of next year, will alleviate policy uncertainties and stimulate economic growth

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This could provide the necessary momentum for Germany's fiscal expansion, with projected economic growth for 2025 estimated at 0.8%, above the commonly held expectation of 0.6%.

With the dollar index currently reported at 107.97, the market is keeping a close eye on these developments.

In terms of bond market dynamics, Morgan Stanley asserts that demand for U.Streasuries will exceed expectations, driven predominantly by banks, foreign capital, and pension fundsDespite a prevailing belief that inflation and deficit forecasts will lead to rising long-term treasury yields, analysts are skeptical and foresee a scenario where these yields remain low.

The report emphasizes that while treasury yields are projected to decrease, structural demand, particularly from key players like banks and foreign investors, could be stronger than anticipatedWith uncertainties surrounding Federal Reserve policy paths, banks may increase their holdings of U.S

treasuries, especially intermediate to long-term bonds, which are expected to offer more "attractive" returns given the favorable holding period yield differential.

Foreign investors' focus is shifting toward the implications of new fiscal policies from the incoming government, which may positively influence their appetite for U.Sdebt amid easing interest rate expectations.

Specific examples from the report highlight the growing interest among Japanese investorsOver the past year, these investors have remained on the sidelines; however, attractive arbitrage opportunities and reduced hedging costs could lead them to pivot towards non-yen-denominated bonds as they seek to enhance their returns.

As for pension funds, the report elaborates that their financial health—characterized by asset values exceeding projected liabilities—could prompt them to rebalance their portfolios in favor of long-term U.S

treasuries in a scenario where long-term rates remain elevated, while stock markets continue to inch higher.

As the eurozone faces its own challenges, analysts at Morgan Stanley argue that despite the prevailing pessimism, there lies potential for the euro to outperform expectationsThis is particularly poignant given the backdrop of dwindling private consumption and external trade policy volatilities that have shaped the European economic outlook.

Market sentiment has been heavily influenced by U.Strade policies, which pose risks to Europe’s already tenuous economic prospectsHowever, the report suggests that the fears surrounding these trade policies may be overstated, particularly with respect to potential impacts on Europe.

Interestingly, Morgan Stanley believes that the extent of easing by the European Central Bank has been underestimated, with a discrepancy of approximately 75 basis points

Should the ECB drive more aggressive easing measures, there is room for economic growth to rise above expectations.

Moreover, external and internal political developments that are favorable could lead to significant reassessments by domestic and foreign investors, compelling them to reallocate capital with greater urgency.

Another noteworthy factor highlighted in the report concerns the potential for capital repatriation to emerge as a key area for unexpected gainsFor instance, while U.Streasury nominal yields exceed those in Germany by more than 200 basis points, this advantage may evaporate once foreign currency hedging costs are considered.

Though Morgan Stanley anticipates yield declines across both U.Sand European markets, it is unlikely for the American yield curve to invert significantlyThis suggests that should favorable conditions arise in Europe, there may be increased willingness among European investors to allocate more resources within their local markets.

As the report wraps up its analysis of the euro, it emphasizes that despite the prevailing negative sentiment, the euro/dollar exchange rate has been trading within a confined range

Should bearish sentiments shift unexpectedly, it could provide momentum to push the euro past its upper trading limits.

In addition to these main points, the report also identifies other potential surprises that could unfold in 2025:

Firstly, a flattening of the SOFR (Secured Overnight Financing Rate) swap spread curve might occur due to U.Streasury issuance falling short of expectations, effectively widening the swap spreadThe Federal Reserve may respond by increasing its purchase of short-term treasuries to rebalance its balance sheet structure.

Furthermore, the Bank of England may accelerate the end of its easing cycle, with persistent inflation constraints limiting its capacity to further reduce rates, which in turn may impact the yield performance of U.Kgovernment bonds.

Japan’s yield curve could flatten under hard landing scenarios or if wage growth does not meet expectations, leading to a "bull flattening" rather than a "bear flattening."

Across the eurozone, despite supportive macroeconomic factors for a steepening trajectory in the 10-30 year yield curve, the ECB’s easing policy and minor repricing of volatility could pose risks to this stance during the early months of 2025.

Lastly, while significant tariffs may not distinctly impact the dollar, a slower U.S