Morgan Stanley Sees Hawkish Fed Sending Note Yields to 2011 High

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Treasury two-year yields may rise to the highest level since 2011 if investors take Wednesday’s Federal Reserve minutes to indicate policy makers will raise interest rates in September, Morgan Stanley says.

Two-year notes have underperformed longer maturities this month as the Fed moves toward boosting the benchmark rate for the first time since June 2006. The central bank will publish the minutes from the July 28-29 Federal Open Market Committee gathering hours after the Labor Department releases consumer-price data for July.

“If investors interpret the FOMC minutes on Wednesday as a signal that liftoff in September is a high-probability outcome, two-year and five-year notes could sell off,” Morgan Stanley analysts led by Matthew Hornbach, head of global interest-rate strategy in New York, wrote in a report dated Tuesday.

Two-year yields may increase by five basis points, and those for five-year notes by 13 basis points, the analysts wrote, citing a chart of different probabilities for the pace of Fed rate increases.

The U.S. two-year note yield was little changed at 0.72 percent as of 7:08 a.m. New York time, according to Bloomberg Bond Trader data. The price of the 0.625 percent security maturing in July 2017 was 99 26/32. The yield climbed to 0.76 percent on Aug. 5, the highest level since April 2011.

The five-year yield was little changed at 1.58 percent, and the benchmark 10-year note yielded 2.19 percent.

Inflation, Jobs

“Investors should focus on how the minutes characterize the Fed’s confidence that inflation will return to 2 percent over the medium term, given that the July FOMC statement already suggested that progress has been made on the employment side of the Fed’s mandate,” the Morgan Stanley analysts wrote.

An index of returns on two-year notes was little changed this quarter, according to Bank of America Merrill Lynch indexes. Five-year securities rose 0.5 percent in the same period, and 10-year debt gained 1.3 percent.

“The Fed probably wants to raise interest rates this year to create a buffer in case the economy slows after six years of expansion,” said Hideaki Kuriki, who invests in Treasuries at Sumitomo Mitsui Trust Asset Management in Tokyo. “The two-year sector pretty much priced in the first rate hike, but the yield could still climb when the timing of the actual move nears.”

Consumer-price inflation slowed to 0.2 percent in July, from 0.3 percent the previous month, according to the median estimate of economists surveyed by Bloomberg before the report.

‘More Upside’

Low inflation expectations are preventing longer yields from rising, while two-year yields have little scope to fall, Sumitomo Mitsui’s Kuriki said. “Yields in the two-year sector are directly affected by policy rates, so there is more upside than downside.”

Futures show a 50 percent probability the Fed will raise its benchmark rate at its Sept. 16-17 meeting, based on the assumption that the effective fed funds rate will average 0.375 percent after the first increase. It has kept its key rate in a range of zero to 0.25 percent since December 2008.

Some investors are more concerned about the pace of rate increases after the initial lift.

“We still think they’re going to raise in September,” Alberto Gallo, head of macro credit research at Royal Bank of Scotland Group Plc, said in an interview on Bloomberg Television’s “The Pulse” with Francine Lacqua. “They are going to raise, but it’s going to be probably the slowest hike path that the Fed has done in history.”

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