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).

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Judge Judy Scheinlok's picture

You already know my opinion about this. QE3 is already underway. This time Oil Exporters step in and buy US Ponzi products with fiatcons given to them by oil thirsty pigs.

This cannot last. There is no equilibrium anymore. Or should I say disequilibrium has become obvious.

equity_momo's picture

There is always equilibrium , your timescale is just off. Wait.

Orly's picture

Important Fed Board members are coming out strongly against any further QEasing.

I think it's a done deal.  Once everyone figures it out, get long USDJPY and USDCHF.

equity_momo's picture

Even that odious fat smug little fuck Meyers was of the opinion QE3 wasnt needed. Although i'd sooner trust Bernie Madoff than any former fed member. Especially that prick.

duncecap rack's picture

You shouldn't hold back. Say what you mean.

strannick's picture

Im still trying to parse your meaning from your opaque euphemisistic diplomat-speak 

RoRoTrader's picture

That is an interesting opinion in the context of trading price, Orly. Tnx for putting out there to read.

Clampit's picture

My biggest question about QE2: how will we know it's ended? Sure there will be some announcement, probably followed by updating of metrics, but given the current power structure I don't see anywhere close to enough accountability and audibility to take the data seriously.

My prediction? The "end" of QE2 magically turns out to be no big deal, and certainly won't precipitate any selloff.

kaiserhoff's picture

When the Fed Audit is made public, right after Hell freezes over.

Quinvarius's picture

They will never stop QE.  They might stop telling the public about it.  But the Fed will continue buying Treasuries.

saltine's picture

If QE ends, US interest rates increase. Then US equities and residential real estate tank. Precious metals correct significantly.

For the life of me, I can't see that happening 15 months before the US elections.

I had dinner last night with a guy who is an analyst for a US based international firm that invests pension and similar funds in large commercial real estate ventures. His firm has accepted as fact that QE is ending.

dcb's picture


take away the fed induced liquidity and asset prices drop, near term inflation elevated, long bond yields drop in value.

look at interest rates in Japn,

The net effect of Qe has been to raise interst rates, now lower them and multiple ZH articles have pointed out that the whole rationale for Qe is flawed based on this fact.


Xkwisetly Paneful's picture

Stop disturbing the herd.

Afterall the overtly obvious always works in calling the markets. Frightening about 100,000 -5 the other side vs this.

Can toss in never ending cheap ass capacity from the Chinese.


Where is that all inclusive chart of QE and everything known to man?

Rogerwilco's picture

The end of QE. Let's see, commodities tank 50%, DX surges to 90, yields on treasuries head for zero. All good from the Fed's perspective. The cost? Hedgies and pension funds get kicked in the balls and their portfolios are 30% off the highs. Win-win!

Bernanke is a hero again, gasoline is $1.75 a gallon, 30-year mortgages are 4%. He bought Obama another two years, maybe even a reelection. Extend, pretend.

Dollar Bill Hiccup's picture

Given the current ramp job in equities, 30% down will still leave the SPX around 1000, a far cry above the day of the devil two years ago.

Maybe we'll see Tupper on CNBC again telling everyone to go short!

Orly's picture

That's exactly what I have been thinking.  The Bernank's actual target was 1050, so they can overshoot to make the market appear to be cratering when it is actually well beyond where they need it to be.

I told you these guys were really, really bright.  No one believed.

Believe it now?

DR's picture

Yea, everyone is waiting to move some of their "risk on" gains into treasuries after QE2. This will put a damper on yields rising too much.

malikai's picture

So what happens to budget deficits then? Uness everyone goes mad on a treasury binge rates are due to soar. How will that look politically during an election cycle? What about the guaranteed recession that will then be blamed on Obama?

jimcg's picture

My guess is that clients paid by the word, graphs were additional.



Robslob's picture

Sweet...huge correction in equities AND precious metals means I can finally close my short positions, double down on gold and silver and have plenty of cash left over for the coming hyper-inflationary event....

That event will be congress taking over the printing presses from the Fed.

buzzsaw99's picture

They have been QEing all along. The only difference now is that it is blatant QEing.

disabledvet's picture

a "collapse in equities" is a beginning not an end to a crisis.

Yen Cross's picture

Long term charts are worthless. It's real TIME.

long-shorty's picture

"All good from the fed's perspective" ???

are you Sheening?

JGambolputty's picture

Bernanke, et al, 2004: "[I]t is crucial that the

central bank’s promises to maintain some part of its quantitative easing as the economy recovers be perceived as credible by the public."

QE2 will be followed by a roll-over period, just as QE1 was.

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