Morgan Stanley On 10 Year Sub 3.00%: Don't Panic, Those Steepeners Will Work... Eventually

Morgan Stanley's Jim Caron in major damage control mode. Try keeping a straight face as you read this.

Our take

Why are UST 10s below 3%? Fear and greed, but mostly fear. Many in the market have surrendered themselves to the deflationistas. It seems to be all over the media these days. Concerns about a deflationary double-dip, rumors of the Fed re-opening QE and purchases of USTs as a liquid positive-carry hedge against risky assets are but only some of the culprits pushing UST 10y yields below 3.00%. We recognize and respect these forces and concede that UST10s can fall further in yield. We will not fight this current move. Instead, we will look for the opportunity to counter it.
 
These forces driving yields lower are real but we believe the market is premature in convincing itself that we are headed into a deflationary spiral with lower growth at this time. The evidence suggests that we will grow at ~3.5% this year in the US and global growth is expected to run at 4.8%. As we have been arguing, economic stability for 2H10 is an underpriced risk and once the macro growth dynamics for 2H take hold, then we expect the upward bias in yields will re-assert itself. The lower yields move now, the more ferociously they will snap back later.
 
What Gives
 
But for now, here are some of the reasons the UST 10y has broken down below 3.00%

1. Fundamental reasons: The most common reason is that people feel the mkt is headed into a disnflationary double dip and buying UST 10s at this level is a good play for that scenario.

2. Hedging reasons: as one long/short equity manager put it to me, "USTs are big and liquid, you've gotta own them". This was in the context of owning USTs as a preferred hedge against their equity longs. They felt owning USTs was akin to owning tail risk. And at least you got paid some carry to own this hedge. If mkt conditions improved, you could exit easily.

3. Asset Allocation and Indexers - these reasons are more technical:

  • people were short/underweight USTs through May. Recently, fund managers have been getting back to a neutral weighting, which implies they will need to buy USTs in the process.
  • as the universe of USTs increase, indexers need to buy more and more USTs to remain at the prescribed weighting of their index.
  • the Fed announced yesterday it was going to swap the 5.5% coupon mortgages it bought during QE for 4.5% coupon mortgages. This was done for liquidity to alleviate delivery fails in the 5.5%s. The impact of moving to a lower coupon is that it's duration is longer. So, if you sell the 4.5% mortgage to the Fed in exchange for a 5.5%, then you are effectively short ~$2Bn UST 10y equivalents. This means you need to BUY $2Bn 10s. This caused the mkt to drop 6bps in UST10y yields in a flash. Also, people speculated this may be a signal QE may re-start, which we think is nonsense.
  • Month-end/Quarter end window dressing. Although there is not much of an extension, managers want to show investors they own nice safe USTs.
  • people view the roll-off of the €442Bn 1yr LTRO in Europe on July 1 as a potential event risk. We disagree with that notion (as per Mutkin's last weekly).

4. Rumors: there have been some articles in the UK Telegraph suggesting that the Fed will enter QE again and buy over $2Tr more in assets. This has not been verified as a reliable source.
 
A Counter Point to the Deflationistas
 
If true deflation fears were at work in the market then one should expect the longest duration points on the curve to rally most and we would see a significant flattening of the yield curve, especially the UST 10s30s segment of the curve. We use this as a check against deflation fears. Instead, we see the opposite with the UST 10s30s curve right up against its 20-year highs. If deflation is truly at work in the market, then someone ought to tell the UST 10s30s curve. And for that matter, all curve segments should be much flatter. Yet the curve flattening has been slow and grudging. Thus the yield curve is more representing an overall shift to lower yields as the Fed is expected to be on hold for a long time, not that deflation is truly at work. Don't confuse the two. It's too early to conclude that deflation is truly at work in the marketplace.
 
Chart: Weekly UST 10s30s Yield Curve since 1990