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How Long Will The Bond-Equity Divergence Continue? Not Much Longer According To Morgan Stanley
So far the stock market has has been having its cake, and eating it with relish too. With stocks having rallied almost 80% from the lows, the one market participant that still seems to not have gotten the memo of a surging economy is the bond market. To the credit of Merrill's Harley Bassman, 10 Year spreads have been trading in a tight range between 3.2% and 3.8% for almost a year (no doubt in big part precipitated by the Fed's control of a vast portion of the bond and MBS market). Should equities take another major leg higher, whether due to NFP or other reasons (most likely momentum inertia), it is very likely that the 10 Year, which many believe has been patiently waiting for deflation to finally be realized, will finally snap its tight trading range and go higher. Much higher. Morgan Stanley sees the 10 Year going wider by 60 bps in the next 90 days.
In a piece titled, "We can get there from here - higher yiels in 2Q '10", MS' Jim Caron states:
The start of 2Q marks an important period in our core thesis for higher rates and steeper curves in 2010. We are calling for UST 10y yields to rise to 4.50% and the UST 2s10s curve to steepen to 325bp during this quarter. The catalyst for this move is a sharp rebound in economic data. We expect to see 2Q growth at 4%, up from 1Q growth at 2%. This may trigger the break in the 9-month UST trading range that would then drive an avalanche of hedge and speculative related flows that could push yields higher and the curve steeper (Exhibit 1, LHS). We can get there from here.
Many believe the much delayed catalyst will be the NFP number, which with stimulus, census, and snowfall, should finally catalyze stocks into the 1,200 range. That this catalyst, as noted, is based on artificial factors, and various monetary and fiscal stimuli, offset by record bond issuance, is presumably irrelevant. Keynes rules.
Pricing a better tomorrow or a double dip. Equities have been rallying and spread product has been tightening in anticipation of an improvement in economic data (Exhibit 1, RHS), but somehow this has been lost on the bond market. It seems that risky assets are pricing a better tomorrow while bond markets are pricing a double dip. We have argued in the past that the record pace of flows into bond funds has been the culprit that has kept yields low and that low yields are more a reflection of these flows and less a statement on expectations for economic weakness. But the caveat is that these flows can turn with a vengeance as the extremely rate-sensitive bond funds risk declining NAVs that may then shift the flow of money into equities, an asset class that can take better advantage of stronger growth rates in what will still be a historically accommodative rate environment.
A line in the sand – where are we right vs. wrong. The performance in 2Q is not only a critical juncture in our thesis for higher rates and steeper curves but it is also a critical juncture in our base case for a rebound in growth to 3.2% 2010 GDP. We need 4% growth in 2Q in order to achieve this base on our forecast. Otherwise if 2Q GDP disappoints with a, say, 3% reading, then it would require that 2H10 grows at ~4.0% to reach our target of 3.2% for the year. A lower 2Q GDP would certainly up the ante for realizing our forecast for much higher yields.
Of course, in the closed circle of interlinked capital markets, a rise in rates would plant the seeds of the markets own eventual destruction as the impact on mortgage housing, on the dollar (once QE 2 is released as rates surge), and on capital flows becomes magnified, and impacts the currently 25% at least overvalued equity market.
Morgan Stanley admits that the only instance in which the bond bearish thesis may be wrong is if we officially enter a double dip.
In the case of lower than expected GDP, the sustainability of a reasonable rebound in growth may be called into question and expectations for slower growth and disinflation may dominate, pushing yields lower and bull flattening the curve. Thus, if the economy is not on track to achieve 4% growth or better in 2Q, then we may be wrong. But if 2Q produces these results, we are likely right in our forecast for higher yields. This is a simplification of how we may validate our rising yield forecast. Clearly there are a lot of nuances; however, this should serve as a general guide.
And while many are glued to each month's NFP which so far has refused to confirm the economic recovery thesis, MS is much more focused on increasing credit demand: another indicator where so far there has been nothing but disappointment (last month's non-revolving retail credit bounce was dictated by nothing more than laxer government student loan lending standards).
The telltale signs we are watching. The demand side of the economy, and its component parts, needs to show marked improvement in 2Q in order for us to aggressively pursue our rising yield forecast. An improvement in the labor data will be a key ingredient for a rebound in final consumer demand. Additionally we need to see a rebuild in inventories and capital spending pick up in anticipation of a sustainable economic recovery. These elements are essential because they are signs of increased credit demand. Note where we differ from consensus in our rates forecast: we see private credit demand coming back sooner and in greater force. This would achieve a crowding-out effect in UST product, thus contributing to a rise in yields. A sign that a bottom in housing had been reached would also create a marked change in sentiment that might even lead some to price MBS supply, further crowding out USTs. And signs of a rise in incomes and consumer confidence would be welcome additional evidence that we are on track for stronger growth. Of course there are many other indicators to watch, but these are the ones we consider most important.
Here Caron brings back the recently trendy and much discussed topic of negative swap spreads.
The weightiness of UST supply is manifesting itself in tighter/inverted swap spreads. The start of 2Q marks the end of the MBS purchase program and is the pinnacle of the exit strategies from governments. The buyer of $1.25 trillion MBS over the past several months is now done. The weightiness of UST supply has finally manifested itself in the inversion of US 10y swap spreads (Exhibit 2). Note that swap spreads have been tightening for the past year in anticipation of larger deficits and greater UST supply − a tightly woven relationship that produces narrower swap spreads (Exhibit 3). But the new twist is that US 10y spreads broke through the psychological zero bound – only now are people starting to pay attention. This is not a case of US credit worsening to Libor, rather it is a testament to the mountainous supply of USTs ($1.7 trillion net in 2010) versus reduced issuance in Libor-related products like MBS ($0 net issuance in 2010). Nevertheless, the weightiness of UST supply and attendant risk for yields to rise are finally manifesting themselves via tighter/inverted swap spreads. This is the first step of many toward rising yields.
Another key catalyst expected by MS: a reorientation of fund flows away from bonds and into equities, precipitating the first negative return in the bond asset class. Alas, as we demonstrated earlier, this will not happen today: last week's equity outflows were among some of the biggest for 2010. We ask the question: just which cohort of the US population will shift away from equities? The same pre-baby boomers who now realize that Social Security is bankrupt and with every uptick in the stock market anticipate a repeat of 2008? These are people who need their annuities, and for whom the risk of a 20% capital loss is too much. In our opinion this is the weakest part of MS' (and PIMCO's) thesis.
Bond market returns aren’t what they used to be – an asset class on the run. Part of our core thesis for UST 10y yields to reach 4.50% in 2Q is that the move would be catalyzed by negative returns in bonds. We believe that the reason bond yields have remained low was because bond funds continued to receive a record pace of inflows (Exhibit 4, LHS). That had the effect of keeping yields low at a point in the economic cycle, and supply cycle, when they should have been rising. But the critical ingredient to these inflows was positive returns. Remember, IG bond funds returned 19% in 2009, which mainly came from spread tightening. In other words, it's quite simple to see why bond yields have remained low, investors are chasing returns, but this is about to change.
We believe that a sustained rise in yields is upon us and bond funds will start to incur losses (losses in NAVs). Those who were chasing returns will run away from losses even faster. Thus begins a route in the bond market that may catalyze a spike higher in yields toward UST 10y 4.50% in 2Q.
Earlier we discussed interest rate risk for the Fed's portfolio. The same is absolutely true for plain vanilla bond funds.
As we stated previously, the interest rate risk in bond funds far surpass the credit risk. Said differently, bond fund performance is more sensitive to a rise in interest rates now more than ever. And that is exactly what is happening today. Notice that bond returns have been trending lower and are now turning negative in March (Exhibit 4, RHS). If one holds an overweight in bonds, as so many investors do judging by the inflows, then they may look to sell their bond holdings. Where will the money that departs from bond funds go? Well, since money tends to chase returns, then maybe equities is a likely target, given that its returns have been good and that asset class has seen outflows.
In short: Morgan Stanley believes that over the next 90 days we will see a 60bps + spike in 10 Year yields. If they are right, the Fed is about to see a $60 billion loss on its recently acquired GSE and other holdings.
Conclusion – opportunities and positioning: We maintain our view for UST 10y yields to rise to 4.50% by the end of 2Q. We argue that the US bond market will underperform the Euro and UK markets. Additionally, we think the technically based rise in yields is doing some tightening for central banks. For example, UST 2y yields rose nearly 30bp over the past few weeks with little in the way of explanation. Globally, the rise in front-end yields has seen forward rates also spike higher – to levels that may be unachievable unless developed markets encounter a V-shaped recovery or if central banks make a policy mistake by hiking rates too much, too fast and well ahead of signs of a sustainable recovery. As a result, owning forward curve steepeners remains a core trade for us. Swap spreads are another matter. On a global basis, these spreads can remain tight or tighten further, given the nature of excessive government supply to fund the government balance sheets in the wake of financial turmoil.
Morgan Stanley's warning should resound well for all those rushing into equities no matter the cost. With the Fed unwilling to tighten regardless of the economic overheating, the bond market will ultimately be forced to spawn its own, involuntary vigilantes who will have to take on the Fed, first by rapid moves in the long-end, which will then rapdily move into the short-end. Recall we already highlighted that recent 4 Week Bill auction Yields have been steadily climbing, and are now in the mid double-digit basis point range. Maybe we misspoke - maybe scratch the word involuntary when referring to Fed vigilantes. And maybe this whole argument is an Easter bunny egg: in the great fight between bonds and stocks, we have yet to see equities come out on top even once. With stock pickers' inherent optimism, are they simply not seeing the fact that once all various stimuli are removed, once the suddenly biggest import market China overheats and tightens officially as well, then the whole V- shape to a recovery, be it in the developed or commodity producing world, will be seen for the mirage it is? We don't know - Q2 will certainly answer many latent questions.
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I'll take the other side of that bet. Old money, cold hard cash money, is going into bonds. Fast money, hot money, leveraged money is goosing the stock market.
I fraking triple dog dare the usa gubmint to let the 10 year go up to 4.5%
http://www.youtube.com/watch?v=8XlPwsmkPHI
I agree. MS, JPM & WFC are all pounding the table about the imminent lift-off in long Treasury yields. Who wants to be in a foxhole with these clowns?
10 yr at 4.5% and a resulting increase in mortgage rates will kill any activity in homes. Now, if you believe, as many do, that a resurgence in new homes is a necessary part of the Recovery (oh, wait, that is already in full swing) then you can kiss that particular "step to full recovery" good bye. Not saying it's not a good idea to get out of that particular rut to escape this Great Recession but I see no other catalyst. The equities market evidently sees something I do not, but I know I don't know it all, and blind faith and hope is not an investment strategy in my book. Sure we might go higher in equities - but why? What is the driver besides Ponzi-ism and greater fool theories? Someone needs to keep pounding the table and reminding everyone that banks in "small business land" are simply not lending. Ignore that fundamental fact at your peril. The base is not moving, despite the ability of these free money sucking behemoths to keep moving.
The equities market evidently sees something I do not...
they see 0% fed funds rate.
Ya mon. A rate few can access. And "real rates" going up will kill the green shoots even with the 0% rate, which is pure string pushing.
Agreed. The spread between bonds and equities is the spread between truth and fiction.
but who even knows what PIMCO does anymore... is everyone talking outta both sides of their mouth?
they could be buying land on Mars for all we know
Well, this I will tell you - SPX should run to just over 1200 before a shallow pull back of 4% or so and then continue higher. We're seeing a complete repeat of what happened off the July low.
Technically, with some minor pull backs along the way, we won't see a meaningful 10% or more sell off until SPX 1350. And when will this occur. Lines up perfectly with the calendar - end of 2010/beginning of 2011.
This plays perfectly into the bond scenario as well. So the way I'm playing it is long and strong until 1350.
It's become the Terminator market. Every crisis known to man (except "locusts" perhaps) has been thrown at it over the past year and absolutely nothing has stopped it, or even knocked it off course. Every theory about what would finally stop the run has proven wrong. Then Ahnuld says "I'll be back" and the trajectory continues. Now about those locusts...
If a treasury purchaser has truly left the market as it seems, rates may go up. If I were a baby boomer I think I would take a guaranteed 4.5% 10 year bond vs. equities at over 22% as reported PE - http://tal.marketgauge.com/dvmgpro/charts/CPERATI.HTM
Reading this, it occurs to me that the part of the economy that is not getting better, a pretty big part, is sort of irrelevant to all this Wall Street happy talk. I suppose that is the point anyway. Better that the few do fine, and the rest eat pound cake.
http://www.huffingtonpost.com/2010/04/01/recession-over-economic-a_n_521808.html
Given the tsunami of Treasury issuance, the 10yr may need to be at 4.5%+ just to find a bid.
That is what I keep telling everybody. We can have deflation and the yields can still go sky high because SUPPLY is massive.
Every MONTH the gvt needs to get $100B more buyers than the previous year. $1.2T a year in new money needs to be found. I think as soon as they anounce QE 2 (or whatever number we are on) the bond vigilantes are going to get active. With yields at their 12 month highs now it won't take much to get everybodys attention.
If you are a big bondholder are you going to let the gvt have unlimited access to lower your investment (sell more and more bonds)? No. You start easing back on the buying, let rates start to go up and force them to slow down the defecits.
They will not throw mortgage rate to the wolves, Team O are giving uncapped guarantees to Frandie to absorb all mortgage losses, their new housing plan will pay defaulting homeowners to service their mortages, so anyone still think they will allow mortgage rate hikes via rise in 10yr yields? If Ben and Tim are not allowed to monetize as Ben would like, up to 30% of GDP, ie you talking about a Fed balance sheet of up to $4 trllion, then the big bazooka will be to pass a bill to legally freeze all mortgage rates and for the Fed to absorb all interest rate risks directly or otherwise. Nothing is too extremist for Team O.
When Team O starts trying to force banks to write down principal, that's when you see banks putting people out in the street. This nonsense has gone on as long as it has because banks got a subsidy to not foreclose.
No matter what they do, all roads lead to clusterfuck.
"bubble-nomics" simply ignores monetary authorities. stop asking it to "revert to the mean." this whole notion of "normative forms of behavior" simply does not apply in this ahistorical circumstance that we find ourselves in. at some point "the data will finally be true!" but in the meantime all you're doing is losing other people's money which is probably why you're here in the first place. markets will stay irrational far longer than you or I will stay solvent. that includes the downside as well, of course--which of course does NOT mean the equity market--and OF COURSE does mean the bond market. insofar as the dollar is concerned, isn't the only thing missing from this "virtuous cycle" is it's collapse? i mean you couldn't script a more perfect scenario for JPMorgan and HSBC with BofNYMellon providing "the back-up." Makes me break out in song when I think about it. "Gonna get down on Shakedown Street, use to be the heart of town. Don't tell me this town ain't got no heart. Use to be the heart of town."
What about the theory that the Fed is pumping up the equity market to the hilt in order to have that money flood the bond market when it inevitably crashes?
Either that or someone is getting "paid off" through a rise in equities...meaning our creditors (ahem China) may have had it up to here with our bonds, our dollars, and financing the rest of our financial mess and wants to see some money and some results now...hmmm, whats the easiest most illiquid financial market to inflate and manipulate higher?
Your theory makes some sense. Would be interesting to see how much China owns in equities. It would make sense for them to put their money in the same place as Americans' 401(k)'s.
Long end rates wil have NOTHING to do with a "recovery". They will spike for systemic, supply side, reasons and the deflate the entire global equity ponzi bubble with it. Disater is imminent. Everything will deflate against wheat.
This is an election year and the stock market rebound is the only serious "accomplishment" the incumbent party repeatedly mentions. The Insurance companies will attack from all angles on HCR which the Dems will show no backbone on. It's apparent to me that the 4O1k Voting block is the one the Dems have set their sights on. No more meaningful legislation will pass. My guess is they will do anything to keep rates down and the stock market WILL GO PAST 1200+ , while the B(L)S should give us +300K jobs per month in the final wind-up to the election.
The market has defied all expectations. Think dot.coms from 1997-2000
I'm thinking of the trickle down moral Harzard economics at work here which cause these bumps in economic activity. It will last longer than people will expect. FAZ will probably have to do another reverse split. I hate it. It makes no sense. That's why it should be solid.
How Long: is a chinaman
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