Monday, April 12, 2010

Morgan Stanley, Goldman Sachs, Treasury Supply, and Bond Yields

A Wall Street Journal article over the weekend showcased the starkly different views of two major financial institutions (Morgan Stanley and Goldman Sachs) as to where bond yields are headed later this year.

The Morgan Stanley view is that 10-year Treasury yields are likely to spike, largely due to pressure stemming from heavy Treasury issuance, hitting 5.5% by year end. On the other extreme of the spectrum, Goldman's chief economist thinks that long-term yields are likely headed toward 3.25% in the midst of low inflation, and considerable slack in the economy that will keep overall credit demands in check. To add an extra twist to the sharply diverging views about the direction of bond yields, those two firms had, according to the WSJ, the best "economic forecasting" record in the last two years. So, what is going on here?

Far from attempting to simply add another view to the mix of what is often a thankless, or even hopeless, exercise of forecasting interest rates, the purpose of this note is to highlight some basic facts on this topic.

Treasury supply, tempting as it often is to enlist as an argument rationalizing a certain interest rate outlook, has historically shown a very weak correlation with the direction of yields on a trend basis.

In the '80s, when the Reagan tax cuts caused the U.S. budget deficit to more than quadruple by the middle of the decade, bond yields declined dramatically during that period, driven by the rapidly falling inflation and the the unwinding of the previously unprecedented Fed tightening. In the late '90s, when the fiscal situation improved dramatically, switching from fairly substantial deficits to sizable surpluses, long-term bond yields fell moderately in late 1998, they rebounded quickly in 1999-2000 under pressure from a robust economy and Fed tightening despite the growing budget surpluses and Treasury paydowns. Moreover, the most recent episode where yields have fallen since 2007- despite the explosion of Treasury supply with no imminent relief in sight, calls further into question, and spectacularly so, the weakness of the relationship between deficits and bond yields.

And, of course, there is also Japan. The most indebted industrialized economy, that has been running massive budget deficits since the '90s, has consistently experienced low bond yields (in the 1% to 2% range) throughout the last 15 years- the result of a stagnating economy and persistent deflationary pressures.

Abrupt changes in the fiscal outlook can, at times, lead to an emotional "front running" of it by markets, with yields moving initially in one direction or another, at times significantly so. However, the "supply" trade usually has somewhat limited shelf life and ultimately more powerful fundamentals determine the trend in yields. In a globally interconnected financial market environment, demand for Treasuries can also increase in a manner that offsets the onslaught of supply. Countries other than China, are stepping in to fill any gap left by that country's possibly more cautious approach toward Treasury purchases. To demonstrate the point, the Chinese were net sellers of Treasuries in late 2009 and around the turn of this year, but Treasury yields did not move appreciably, as Japan and other key emerging market economies with growing official reserves (Brazil, Russia and others) are making up for the difference.

Back to the divergence between Morgan Stanley's and Goldman's view on rates for 2010: Long-term yields can come under pressure at some point (with the sustainability of any such back-up still subject to questioning), as the recovery takes hold and the market goes through bouts of uneasiness over the timing of the Fed's exit strategy. But a back-up in the 10-year yield to 5.5% because of heavy Treasury supply, as Morgan Stanley predicts, feels like reducing a pretty complex financial and economic environment to something disturbingly simplistic.

Anthony Karydakis

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