Morgan Stanley’s piece on Treasuries Priced for Perfection…for Now! is pretty bearish. The basic gist is that while the ten-year represents fair value today, because inflation expectations have become unanchored, Morgan Stanley expects the yield to rise from 3.3% to 5.5%. That’s a disaster of 1994 proportions. Obviously, given some of my recent comments, this is not what I expect to happen, but be well aware of the risk; in this economic environment, it would be fatal.
Here’s an excerpt of what Manoj Pradhan had to say (emphasis added):
Fed Chairman Bernanke’s speech on Monday could not have been better tailored to keep bond markets happy. The commitment to keep policy rates “exceptionally low” for an “extended period” and the benign outlook for inflation were both very well received by bond markets, as well as other risky assets… Our proprietary model, MS FAYRE, shows a current fair value of 3.3% for the US 10-year Treasury yield – bang in line with actual yields…
Priced for perfection… MS FAYRE generates its fair value estimate using the real Fed Funds rate, 1-year ahead CPI inflation expectations from the SPF conducted by the Philadelphia Fed and the 5-year rolling standard deviation of inflation as a proxy for inflation volatility (for more details on the MS FAYRE model, see Fairy Tales of the US Bond Market, July 26, 2006). With the Fed Funds rate at 12.5bp, core PCE inflation tracking at 1.3% and the 4Q09 number for 1-year ahead CPI inflation expectations from the SPF coming in at 1.6%, MS FAYRE produces a fair value of 3.3% for 10-year bond yields, which is exactly where the 10-year yield is now (interested readers should contact us for a user-friendly spreadsheet for simulating the FAYRE model). Forward-looking bond markets thus seem to be pricing in altogether too rosy a scenario for the foreseeable future.
…for now: With actual bond yields bang in line with our fundamental fair value estimate, investors seem to be receiving no compensation for macroeconomic or fiscal risks..
Our forecasts look for bond yields to rise in 2010: Our US economics team expects bond yields to rise to 5.5% by the end of 2010 – an increase of 220bp that outstrips the 137bp increase in the Fed Funds rate expected over the same horizon (see Don’t Fear the Double-Dip, October 6, 2009). Our US interest rate strategy colleagues suggest that this bear steepening of the curve in 2010 may well be preceded by slightly lower 10-year yields in 2009 (see Liquidity Aplenty but Rising Sensitivity to Rates, October 22, 2009)…
Inflation expectations don’t seem to be anchored… The SPF measure of long-term CPI inflation expectations in the US has indeed remained stable, as claimed, since the median expectations have held steady for nearly a decade now. However…
…our conversations with clients also suggest a split into two fairly distinct camps. A smaller set of clients are bearish on the economic outlook and believe that inflation will be extremely low or even be outright negative for the next few years. The rest believe that inflation risks, and probably inflation itself, will rise within a year or so as the recovery becomes sustainable. The important point here is that it is difficult to find investors who believe that inflation over the medium-to-long run will be precisely in line with central bank targets. Both pieces of evidence do not support the argument that inflation expectations are anchored.
Obviously, Morgan Stanley is bullish on the economy because they are talking about a bear steepener across the Treasury curve. Their thinking on Treasuries is one reason you see Barack Obama talking about reeling in deficit spending. He obviously believes that an increase in interest rates would trigger a double dip recession.
My thinking goes more to bull flatteners where the two-year – ten-year spread decreases as expectations of a fed rate hike are countered by weak economic fundamentals. This dichotomy points out some very real risks in the bond market right now.
Bill Gross his on the record expecting Treasuries to rally because he is cautious on the economic environment.
Gross has been talking about a “new normal” of deleveraging, deglobalization and reregulation. In his view, this means weak consumer demand counterbalanced only by heavier government intervention, leading to slow growth for the foreseeable future (See my post ‘Gross: The new normal for “the next 10 years and maybe even the next 20 years”’). In essence, he sees a scenario that is bullish for bonds (especially longer duration types like the 10-year and the 30-year) but not particularly bullish for shares.
But we know that Gross loves to talk his book and he made billions from the Fannie/Freddie bailout doing so. You have to make your own call here. It’s Morgan Stanley on one side of the trade and Pimco on the other.
Realistically, if rates spike to 5.5%, it would be a blood bath for insurers, and probably for pension funds (and hence municipalities as well). Mortgage rates would skyrocket and this would stop any housing recovery dead in its tracks. That sounds like double dip and depression to me; this is not an early 1990s economic environment.
Ironically, 5.5% rates would sow the seeds of future 3.3% rates or lower. If you hold – and do not sell at the bottom – I don’t see how this induces a capital loss.