With the 10-year Treasury yield recently hitting its highest point since 2013, the consensus is bearish on long-term bonds. Morgan Stanley strategists have a different take.
After dipping to 2% in September of 2017, the 10-year U.S. Treasury has steadily climbed higher, prompting many bond pundits to declare the more than 30-year bull market in bonds officially over.
Although the 10-year Treasury recently hit its highest yield in more than four years, several factors indicate the contrary.
That view gained momentum in late February when the benchmark yield climbed past 2.9%—more than twice its historic lows in July 2016—following a Congressional question-and-answer session with the new Federal Reserve Chairman Jerome Powell.
Yet, even with yields hovering around 3% for the first time since 2013, investors should not be so quick to accept the bearish consensus view. “Every time the bond market moves dramatically and unexpectedly higher in yield, the consensus forecast plays catch-up,” says Matthew Hornbach, Global Head of Interest Rate Strategy for Morgan Stanley Research. “We don't feel compelled to join that crowd yet.”
In a recent Morgan Stanley Research report, Hornbach and his colleagues note that the consensus view on 10-year Treasuries often misses the mark, whether in timing, direction or magnitude. Even after yields stabilize, Hornbach adds, the consensus forecast continues to shift higher in what is likely a reflection of negative sentiment and recency bias following a large sell-off.
Morgan Stanley’s fixed income strategists believe that the yield curve will flatten as the two-year yield moves higher and the 10-year yield retraces its recent gains; their base case calls for 10-year Treasury yields to end the year much lower than the consensus suggests.
On the short-side of the yield curve, the consensus seems to interpret the Federal Open Market Committee's recent use of the word “gradual” as an indication that it will allow inflation to run higher than 2% in order to make up for the last 20 years of below-target growth. “Don't let the word 'gradual' fool you,” says Hornbach. “It does not preclude the median dot from moving up to four hikes in 2018 and three hikes in 2019—something that may very well occur at the March FOMC meeting.”
Although, the 10-year Treasury recently hit its highest yield in more than four years—suggesting that investor demand for these securities is waning—several factors indicate the contrary. For one thing, 10-year yields elsewhere in the world remain significantly lower, which is to say that global investor demand for U.S. notes should hold steady.
Meanwhile, a secular shift to safety offers an added tailwind. As Morgan Stanley's Global Co-Head of Economics Elga Bartsch explained in a recent Global Macroeconomic Briefing, investors are willing to pay a premium for safe, liquid assets.
Consequently, U.S. Treasury yields have, over the last 30 years, declined more than high-quality corporate debt yields, yields on productive business capital and S&P 500 earnings. According to a New York Fed paper, more than half of the estimated decline in trend interest rates since the late 1990s can be explained by an increase in the safety and liquidity premia investors are willing to pay. Barring a major shift in demographics or sentiment, that trend should continue.
“It is too soon for FOMC participants to begin raising longer run dots with the view that the longer run neutral rate is rising, but it's not too soon for participants to increase the pace of projected rate hikes,'” Hornbach says. “This keeps us in the yield curve flattening camp.”