Morgan Stanley, the most bearish among the 18 primary dealers that trade government securities with the Federal Reserve, acknowledged that its forecast that Treasury yields would rise this year was misguided.
“We got our rates call wrong and missed a great opportunity to be long bonds this year,” James Caron, head of U.S. interest-rate strategy at Morgan Stanley in New York, wrote in a note to clients yesterday. “The market is currently rife with tactical relative value opportunities and that’s what we will focus on going forward.”
Morgan Stanley had forecast that a strengthening U.S. economy would lead to private credit demand, higher stock prices and diminish the refuge appeal of Treasuries, pushing yields higher. David Greenlaw, chief fixed-income economist at Morgan Stanley, said in December that yields on benchmark 10-year notes would climb about 40 percent to 5.5 percent, the biggest annual increase since 1999. The New York-based firm reduced its forecast to 4.5 percent in May and to 3.5 percent last week.
Other primary dealers weren’t much better at predicting yields, according to a March survey by Bloomberg News. Jefferies Group Inc. said the 10-year would yield 4.75 percent by year- end. Deutsche Bank AG, JPMorgan Chase & Co., and Royal Bank of Canada estimated a rise to 4.5 percent. The most accurate dealers so far have been Goldman Sachs Group Inc., with an estimate of 3.25 percent, and HSBC Holdings Plc at 3.3 percent.
‘Risk Weighted Return’
The 10-year note yield fell as much as 4 basis points to 2.53 percent today, the lowest level since March 2009. Yields have declined 10 basis points in the last five days and about 46 basis points in four weeks.
Caron is advising clients to buy shorter-term Treasuries maturing in 5 years or less and 1- and 2-year forward contracts.
“If the Fed is going to be on hold for an extended period of time, then that’s the sector that is going to perform the best and it also has the best risk-weighted return,” Caron said today in an interview with Thomas R. Keene on Bloomberg Radio.
Morgan Stanley also recommends profiting from the narrowing of the gap between the yields on 10- and 30-year Treasuries. The difference narrowed to 106 basis points today, after touching 125 basis points on Aug. 10.
“It’s mainly about the 30-year bond yield coming lower,” Caron said today, adding that 10-year yields may remain low as the Fed buys more Treasuries.
Policy makers began a purchase program on Aug. 17 to keep borrowing costs low to foster economic growth by reinvesting principal payments on mortgage-backed bonds and agency debt into Treasuries. The Fed bought $6.16 billion in debt this week. It acquired $300 billion of government debt last year.
Caron is recommending that investors position for the Fed’s purchase of Treasuries on Aug. 24, 25 and Sept.1.
“We believe that U.S. Treasury 10-year yields will be range-bound from 2.85 percent, where the Fed announced it would buy U.S. Treasuries, to 2.40 percent near-term,” Caron wrote.
Morgan Stanley also cited that it thought yields would move higher because the Fed would be more likely to raise interest rates in the first half of this year and the unprecedented supply of Treasuries to weigh on prices, Caron wrote. The market suggests the central bank will keep its target rate for overnight loans between banks at a record-low range of zero to 0.25 percent well into next year, he said.
Shrinking credit markets may help explain why some Treasury yields are at record lows even after the amount of marketable government debt outstanding increased by 21 percent from a year earlier to $8.18 trillion.
‘We’ve Been Wrong’
While net issuance of Treasuries will rise by $1.2 trillion this year, the net supply of corporate bonds, mortgage-backed securities and debt tied to consumer loans may recede by $1.3 trillion, according to Jeffrey Rosenberg, a fixed-income strategist at Bank of America Merrill Lynch in New York.
Morgan Stanley may revise its forecast for 3.1 percent gross domestic product growth this year if economic data continues to be weak, Caron said today. The firm is “unimpressed” with recent data, including unemployment claims, payroll and retail sales, he said.
“We’ve become a lot more short-term and tactical,” Caron said. “Once in a while you have to say we’ve been wrong, and here’s why and it’s time to move on.”