(Bloomberg) -- The US dollar has peaked and is set to decline in 2023 along with Treasury yields on expectations of easing inflation, a scenario that will support emerging market assets, according to Morgan Stanley. 

The dollar index will slide to 104 by the end of next year, while the euro will outperform as investor flows resume, Morgan Stanley analysts led by Andrew Sheets wrote in a note, adding the US 2-year and 10-year yields are seen ending 2023 at 3.50% – implying a meaningful steepening of the yield curve.

The dollar is expected to peak as uncertainty around the Fed rate tightening abates, with the Fed forecast to make the final rate hike in January 2023, with a rate cut to follow in the fourth quarter, while the European Central Bank to make the final rate increase in March of the same year, according to the US bank.  

 

The largest Federal Reserve rate hikes in at least a generation sent the greenback rallying this year, with a gauge of the dollar rising as much as 19%, which would be the largest annual gain on record in data going back to 1972. The euro-dollar fell below parity for the first time in two decades, while emerging-market bonds tumbled by as much as 15%, the lowest returns in 10 years. 

Emerging market bonds are expected to flourish next year, riding on an easing in the EM rate cycle. Several large EM central banks, which front loaded rate hikes ahead of the developed peers, are forecast to ease materially.

Here are Morgan Stanley’s key trades:

  • In the DM rates space, to receive a euro 5-year, 5-year swap
  • Within the DM currency arena, long EUR/GBP is a key relative value view, as well as long NZD/USD
  • In EM, receive 2-year Brazil swaps, which profit when rates fall, and pay 5-year yuan non-deliverable interest rate swaps, which gain when rates rise
  • Expect a 14.1% total return for EM credit, driven by a 5% excess return and a 9.1% contribution from Treasuries. In local markets we see an even stronger total return of 18.3%
  • Brent oil prices to rise to $110 per barrel by end of next year

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