Morgan Stanley Sees 5.5% Note as U.S. Faces Deficits

Bloomberg | December 28, 2009 | 06:03 EST

If Morgan Stanley is right, the best sale of U.S. Treasuries for 2010 may be the short sale. Yields on benchmark 10-year notes will climb about 40 percent to 5.5 percent, the biggest annual increase since 1999, according to David Greenlaw, chief fixed-income economist at Morgan Stanley in New York. The surge will push interest rates on 30-year fixed mortgages to 7.5 percent to 8 percent, almost the highest in a decade, Greenlaw said. Investors are demanding higher returns on government debt, boosting rates this month by the most since January; on concern, President Barack Obama’s attempt to revive economic growth with record spending will keep the deficit at $1 trillion. Rising borrowing costs risk jeopardizing a recovery from a plunge in the residential mortgage market that led to the worst global recession in six decades.

“When you take these kinds of aggressive policy actions to prevent a depression, you have to clean up after yourself,” Greenlaw said in a telephone interview. “Market signals will ultimately spur some policy action but I’m not naive enough to think it will be a very pleasant environment.” Yields on the 3.375 percent notes maturing in November 2019 climbed 4 basis points to 3.84 percent at 11 a.m. in London today, according to BGCantor Market Data. The price fell 10/32 to 96 5/32. They have risen 65 basis points this month, the most since April 2004, as government efforts to unfreeze global credit markets lessened the appeal of the securities as a haven.    

Treasury Futures

Speculators, including hedge-fund managers, increased bets that 10-year note futures would decline more than fivefold in the week ending Dec. 15, according to U.S. Commodity Futures Trading Commission data. Speculative short positions, or bets prices will fall, outnumbered long positions by 52,781 contracts on the Chicago Board of Trade. It was the biggest increase since October 2008. In a short sale, investors borrow securities and sell them hoping to profit by repurchasing the securities later at a lower price and returning them to the holder.

Ten-year notes will end 2010 at 3.97 percent, according to the average of 60 estimates in a Bloomberg News survey that gives greater weight to the most-recent forecasts. Edward McKelvey, senior economist in New York at Goldman Sachs Group Inc., the top-ranked U.S. economic forecasters in 2009, according to data compiled by Bloomberg, expects yields to drop to 3.25 percent. Goldman Sachs says unemployment will average 10.3 percent in 2010, hindering the recovery.

Treasury’s Competition

The U.S. will face increased competition from other debt issuers, spurring investors to demand higher yields as the Federal Reserve ends a $1.6 trillion asset-purchase program, according to James Caron, head of U.S. interest-rate strategy in New York at Morgan Stanley. The central bank was the largest purchaser of Treasuries in 2009 through a $300 billion buyback of the securities completed in October. The Treasury will sell a record $2.55 trillion of notes and bonds in 2010, an increase of about $700 billion, or 38 percent, from this year, Morgan Stanley estimates. Caron says total dollar-denominated debt issuance will rise by $2.2 trillion in the next 12 months as corporate and municipal debt sales climb.

Mortgage Rates Rise

Mortgage rates last reached 7.5 percent in 2000 as productivity gains slowed after the demise of some Internet companies. The average rate on a typical 30-year fixed-rate mortgage climbed to 5.05 percent in the week ended Dec. 24, according to McLean, Virginia-based Freddie Mac. Yields on mortgage securities issued by Fannie Mae rose to a four-month high of 4.54 percent last week. Fannie and Freddie securities are used to guide borrowing costs on almost all new U.S. home lending. Higher borrowing costs as the U.S. shows signs of beginning to emerge from the longest economic contraction since the 1930s puts Treasury Secretary Timothy Geithner in a situation similar to one faced by his predecessor Robert Rubin. “This is the re-emergence of the bond market vigilantes,” said Mitchell Stapley, the Grand Rapids, Michigan-based chief fixed-income officer for Fifth Third Asset Management, who oversees $22 billion. “The vigilantes are saying, OK guys you want to do this, you’re going to pay a higher price for it.”

Bond Market Signal

Inflation-adjusted 10-year note yields have more than tripled this year to 1.5 percent at the end of November, according to Bloomberg data, subtracting the gains in the consumer price index excluding food and energy from the nominal yield on the securities. A surge in so-called real yields to a seven-year high in the 1990s was viewed by the Clinton administration as a sign that they needed to address growing budget deficits, Greenlaw said. “Rubin went to Clinton and said we have to do something to support the recovery, and taxes went up,” Greenlaw said. “You don’t really start to put pressure on policy makers to respond until the market sends a signal.” Sales of existing homes rose 7.4 percent last month, following October’s 10.1 percent gain. The difference between two- and 10-year yields to a record 2.88 percentage points on Dec. 22 as traders added to bets a recovery will fuel growth and inflation. The yield curve contracted a day later after a separate report showed sales of new homes unexpectedly fell in November.

‘Indigestion Problems’

“When you couple the growing probability of a belief in a recovery combined with the supply, it could mean some indigestion problems for Treasury yields,” said James Sarni, senior managing partner in Los Angeles at Payden & Rygel, which oversees $50 billion. “As long as the demand is there, the supply won’t be a problem. I think what’s going to happen is there’s going to be a problem with the demand.” Spending by Obama and lawmakers is increasing as the Fed winds down its stimulus programs. The Senate voted on Dec. 24 to raise the limit on federal borrowing to $12.39 trillion, enough to tide the government over for about two months. The House approved the legislation Dec. 16, along with a $154 billion aid package to pay for extended unemployment benefits, new infrastructure projects and help for state governments. Greenlaw says the U.S. will probably have to offer investors such as foreign central banks and mutual funds real returns of more than 3 percent for 10-year notes to attract funding.

Deficit Spending

“There’s no free lunch, and when you take these kinds of aggressive policy actions to prevent a depression, you have to clean up after yourself,” Greenlaw said. “Foreign central banks are just not going to be able to finance these kinds of budget deficits for very long.” Monetary officials in China, Japan and other countries helped Geithner lower U.S. borrowing costs by 15 percent in the government’s 2009 fiscal year. Indirect bidders, a group of investors that includes foreign central banks, purchased 45 percent of the $1.917 trillion in U.S. notes and bonds sold this year through Nov. 25, compared with 29 percent a year ago, according to Fed auction data compiled by Bloomberg News. The decline in interest expense was the biggest decrease since before 1989 and came even as the nation’s debt increased by $1.38 trillion this year to $7.17 trillion in November, the data show. An increase in yields may even add to demand for Treasuries, said Ian Lyngen, a senior government bond strategist at CRT Capital Group LLC in Stamford, Connecticut. He doesn’t anticipate 10-year note yields rising above 4.25 percent in the first quarter.

Foremost Concern

“The data has yet to prove definitively more bullish for the economy and more bearish for the bond market,” Lyngen said. “A significant backup in rates will simultaneously make the debt more expensive for the Treasury and potentially make it more attractive for investors to buy.” White House officials have acknowledged the bond market’s message about the need to cut the federal deficit. Rahm Emanuel, Obama’s chief of staff, said on Nov. 17 in a speech in Washington that a plan for reducing budget deficits “is foremost” on the president’s mind. “Could one imagine the market for debt being saturated? Of course,” said Lawrence Summers, director of the National Economic Council, speaking in New York on Oct. 8. “We will not, as a country, as the economy recovers, be in a position to issue federal debt on anything like the scale that was appropriate to issue federal debt during a profound economic downturn.”

Jenni LeCompte, a Treasury spokeswoman in Washington, declined to comment on higher borrowing costs. Morgan Stanley’s Caron predicts the spread between 2-and 10-year yields will rise to 3.25 percentage points next year. “There is a lot of supply coming to the markets next year,” Caron said. “In 2009 there was a lot of support for that supply. The question going forward is what happens when there is not.”


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