Morgan Stanley Launches Fed Frontrunning Toolbox, Asks What The End Of QE2 Will Look Like For Rates

Tyler Durden's picture

By now it is no secret that the end of QE2, should one actually transpire as the alternative is surging bond yields which as described yesterday means gross interest expense as a percentage of total US revenue would hit a Weimaresque 30%+, the collapse in equities will be dramatic, once the marginal buyer of up to $8 billion in daily risk disappears, and as was further pointed out recently, the only variable that every asset class correlates with with no exception is the Fed's balance sheet. And while the drop in equities is all but guaranteed, a more important question is what happens to not only Treasury rates but to the shape of the curve. Even though the jump in rates seems inevitable (to those whose career does not depend on pursuing the lemming-like call of the sellside groupthink wild), the finer nuances in the curve shift have not seen a broad discussion. Morgan Stanley's Jim Caron, whose predictive track record leaves much to be desired, has released an analysis of what the end of QE2 will look like from a rates perspective. We urge readers to take this analysis with the same dose of skepticism as any FX recommendation from Goldman's Thomas Stolper.

From Morgan Stanley:

  • The main focus of the Fed in implementing QE2 has been to drive real yields lower and inflation expectations higher
  • The Fed was largely successful, judging by the fact that by the time QE2 was officially announced in November 2010, the market had already driven 5y and 10y real yields to as low as -0.60% and +0.35%, respectively, and 5y5y inflation breakevens – a measure of inflation risk premium – to as high as 300bp in anticipation of the Fed’s goal
  • As the amount of purchases left in the program falls to zero as we approach the end of QE2 by June 30, 2011, the market should begin to unwind the Fed’s impact on both real rates and inflation breakevens
    – Higher Real Yields
    – Flatter Inflation Breakeven Term Structure
  • Further, the very back end of the nominal curve – i.e., 10s30s – should flatten

 

  • MENA Turmoil Complicates Fed Exit
    • A combination of the flight-to-quality bid for Treasuries out of the geopolitical turmoil in the Middle East / North Africa (MENA), along with a crowding out effect of rising 5y inflation expectations out of the rapid rise in oil prices have pushed our interpolated measure of 5y real yields back to 0%
    • The practical implication is simple – investors who own Treasuries in this part of the curve are expected to earn zero additional return in excess of inflation
  • But Presents a Better Entry to Short Real Yields
    • While the recent real yield rally is occurring at a time of widening breakevens as nominal yields remain bid – it is not obvious that real yields should fall to accommodate higher breakevens at a time when the US economy is improving
    • Rising inflation amid stable nominal yields was the modus operandi during the stagflation years in the early 1970s in the US, when real yields were falling – NOT our core call
    • Apart from selling 5y real yields outright via TIPS, investors may also wish to play for a rise in 5y real yields by entering 5s10s real yield flatteners via TIPS, where this curve is currently at its steepest levels in history at 110bp although steeper real yield curve is largely in line with our core view in the US and they may not flatten too much

  • The second coming impact of the end of QE2 is for a flatter inflation breakeven term structure, as the market takes out the inflation risk premium that was baked into BEI at start of QE2
    • This has already started to happen over the past 2M
    • The term structure completely invert by end of 2011
  • Oil Risk / Reward Still Supportive of Front-End BEI (and therefore BEI flatteners)
    • What makes a flattening of this term structure particularly compelling at the present time is that the recent run-up in oil prices, where Brent is at $115/bbl
    • While a sharp reversal in the price of oil is the biggest risk to our view, our commodity strategists still view the risk / reward as being skewed to the upside
  • What Upside Is Left in BEI Flatteners? Roughly 40-50bp
    • 2y inflation swaps are still 40-50bp below 10y inflation swaps, while we think this spread should converge to 0
    • Further, because 2y inflation swap levels are lower than those of 10y inflation swaps, entering a flattener here is positive carry – provides staying power in the trade
    • Our economists now anticipate the CPI can rise by 2.6% in 2011 – a level that has historically been associated with a flat to even slightly inverted inflation term structure

  • A Simple Model Can Be Used to Explain the 10s30s Curve
    • When 2s5s flattens / steepens, 10s30s will steepen /flatten to reflect the pushing out of Fed hikes in time, for
      which our 2s5s curve acts as a proxy
  • UST 10s30s Remains ~20bp Too Steep
    • Today, the 2s5s nominal curve is back to pricing in a healthy level of Fed hikes – in fact, back to levels not seen since 1H 2010, right before the EU peripheral funding crisis flared-up
    • Yet the 10s30s nominal curve is ~20bp steeper today than it was at that time – which leads us to believe that this curve has room to flatten
  • End of QE2 Is Also Supportive of a Flatter 10s30s Curve
    • During QE2, only 6% of the Fed’s purchases took place in the >10y part of the curve – this contributed to its steepness
  • Risk to Our View Is If the Economic Outlook Worsens
    • This will cause the 2s5s curve to flatten – steepening 10s30s – and causing expectations of another round of quantitative easing to rise.

And lest we forget what Morgan Stanley's ultimate motivation is, here is the firm announce the launch of its UST Relative Value Trade Finder: translation - your one stop shop to frontrunning the Fed.

  • Our recently revamped Treasury ‘Trade Finder’ now provides 3 alternative trade switch options for a given bond that’s trading rich/cheap on 3M LIBOR-OAS. Ranked by the spread of spread z-score, we provide both the spread of spread and yield spread metrics (last, average, st. dev, z-score, and RD&C).
  • We have also broken down the trade switches by sectors (1-2y, 2-3y, 3-5, 5-7y, 7-10y, and 10-30y) so clients can easily identify trade switch options within the sectors they want (see page 16-17 of our Daily Treasury RV report).