With inflation slowly moving lower, government bonds are looking increasingly more attractive and may be primed for a comeback later this year.

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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley's Chief Fixed Income Strategist. Along with my colleagues bringing you a variety of perspectives, today, I'll be talking about the case for government bonds. It's Friday, July 14th at 11 a.m. in New York. 

With the U.S. labor market remaining resilient, the prospects for bond markets would depend critically on the outlook for inflation. Our economists expect core inflation to continue to move lower, slowly but surely, shifting consumption patterns in which spending on services slows while goods consumption continues to contract, will weigh on core inflation.

Recent data have been supportive of this expectation. The June employment report we got last Friday, showed a slowing in the services sector earnings growth. Overall, average hourly earnings moved sideways and still are higher than the historical averages. But the average hourly earnings for the services sector decelerated again in June. Though two months do not establish a firm trend, the deceleration in service's average hourly earnings since April is good news for the inflation outlook. The Consumer Price Index and the producer price index  data that we got this week also reflect this ongoing deceleration in inflation. On a year-over-year basis, headline inflation came down to 3% while core inflation came in at 4.8%, down from 5.3% in May. Core Producer Price Index also came in below consensus and is now running at 2.6% year-over-year, down from 2.8%. 

This moderation in economic activity and inflation goes beyond what many Fed officials would consider their model expectations. Such a deceleration, even if associated with a soft landing, could see them adjusting their current hawkish stances. 

Of course, in the best environment for government bonds, central banks are actively easing monetary policy, an environment our economists see taking shape at the end of the first quarter of next year. As such, expected returns for government bonds this year, while admirable, may be closer to average calendar year return than the returns typically delivered during the recessionary periods. At the same time, we think government bonds could perform even better than average, considering the risks that markets are not pricing in. 

The possibility that central bank hikes to date may weigh on economic activity into year end, and that inflation is likely to fall meaningfully into year end with sticky components becoming less sticky, increases the attractiveness of government bonds in our view. Hence, while they have been battered and bruised, government bonds look primed for a comeback in 2023. 

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