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United States Bear Market in Treasuries Begins, but Watch for Deflation Risks United States US Economic and Interest Rate Forecast: Recovery Closer, but Risks Persist View GEF Archive

		The Global Economics Team

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The latest rise in Treasury yields resulted from a poorly received 30-year bond auction last week.  The auction tailed 10bp (tail is the difference between the median bid and the high yield that was accepted – it’s considered to be a measure of the degree of investor demand for the security; and the average for the five prior bond auctions was about 5bp).  In the wake of last week’s poorly received auctions, we have been asked by investors about the possibility of a failed auction in the US.  The UK experienced a failed Gilt auction a few weeks ago.  However, it’s extremely unlikely that anything like that will happen in the US.  The US and UK auction systems are very different, and even though last week’s US auctions went poorly, the bid/cover ratio at the 30-year auction was 2.1 – meaning that more than twice as many bids were submitted as securities offered.

This yield backup seems to fly in the face of the Fed’s aggressive program announced at the March 18 FOMC meeting to buy up to US$300 billion in longer-term Treasuries over the following six months as an adjunct to ‘credit easing’.  Immediately following the announcement of that decision, 10-year Treasury note yields plunged by nearly 50bp to 2.5%, pulling mortgage yields with them.  Since that time, however, 10-year Treasury yields have retraced more than their initial plunge, jumping by 14bp in the past week to 3.25%. 

The Fed has not abandoned this program; far from it.  At the April 28-29 FOMC meeting, it reaffirmed its commitment to use all available tools to fight recession and the risk of falling inflation.  But we don’t think officials will aggressively fight rising Treasury yields.  They probably don’t have a numerical Treasury yield target; rather, they care much more about the level of private borrowing rates and the economy.  Mortgage yields and other consumer borrowing rates matter for economic performance, and those rates haven’t yet backed up much, if at all.  Current-coupon MBS yields have moved back over 4%, but retail 30-year fixed mortgage rates have remained under 5%.  Issuance of TALF-eligible ABS securities has expanded significantly and spreads against Libor have narrowed considerably.  So, the need to step up Treasury purchases seems small.  Moreover, if the economic improvement is genuine, the Fed’s focus will turn from credit easing and purchases of longer-term securities towards exit strategies.  We suspect that officials prefer a gradual exit sooner rather than a wrenching adjustment later, so capping yields in today’s context seems counterproductive to us.  This fits the FOMC’s recent script:  “The Committee will continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets.”

How far might yields back up?  To answer, it is helpful to analyze the three basic elements included in Treasury yields: A real yield, an inflation component and a risk or term premium.  Last week’s events certainly reinforced the notion that supply is weighing on the Treasury market and pushing real yields higher.  An improvement in the tone of the incoming data and associated long-run inflation fears appear to have played some role, but we believe that the bulk of the rise in yields over the past couple of months has been driven by the forces of supply and demand.

Treasury supply continues to grow relentlessly, so the federal government debt-to-GDP ratio is rising rapidly and is headed for a post-WW II high.  Another supply metric is the volume of gross coupon issuance.  We estimate that the market will need to absorb about US$2 trillion of coupons both this year and next.  Moreover, Treasury debt managers are trying to increase the average maturity of their outstanding debt, so the duration of the new supply is on the rise.  This is changing the balance between Treasury supply and demand, boosting the real component in rates.

Second, incipient signs of recovery have virtually eliminated the systemic ‘tail’ risk in the economy and have fueled a flight from quality.  That switch out of Treasuries has reduced demand for risk-free debt, adding to the lift in real yields.  And it has reversed some of the previous compression in Treasury term premiums.  (We define the term premium as the excess of the yield on a longer-dated (say, 10-year) note over the weighted average of expected short-term rates.  On average, it is the extra return an investor earns by holding a 10-year note instead of rolling over a sequence of short-term deposits to the same maturity.  In other words, the term premium compensates investors for the risks in holding the longer-duration security.  Real world effects of taxes, compounding and convexity make this description an approximation – but a good one – of reality.  The increase in distant-horizon forward rates (such as 9-year forward 1-year rates) relative to 10-year yields suggests that term premiums have recently risen.)   For example, Macroeconomic Advisers estimates that a model-based calculation of 10-year Treasury zero-coupon term premiums has jumped from near zero in mid-March to just over 50bp at the end of last week.

Whether the timing and strength of the incipient recovery will match market expectations will critically determine the scope of the further backup in Treasury yields.  Aggressive policies have improved financial conditions and are promoting recovery marginally faster than we anticipated a month ago.  But significant risks remain for credit quality, employment, inflation, profit margins, capex and state and local outlays.  And the tepid recovery we expect leaves the economy vulnerable to shocks, especially in the context of a global recession.  Despite hopes for a virtuous circle between rising markets and an improving economy, therefore, we think the rally in risky asset markets is overdone, and that, in Treasuries, some consolidation or a bear market rally is likely (see Recovery Closer, but Risks Persist, May 11, 2009).

It is important to note that, despite the recent backup, real rates are historically at very low levels.  One reason that real rates remain relatively low is the Fed’s pledge to purchase a significant volume of Treasuries (US$300 billion by September 2009 – or about one-third of the gross new supply over that timeframe).  Moreover, the market is well aware of the fact that the Fed can always increase the size and lengthen the duration of the Treasury purchase program (as it did with MBS/agencies).  Another reason that real rates are low is the dearth of competition from private credit demands that typifies recession; the pace of private borrowing has fallen steeply over the last few quarters.  Not surprisingly, the bulk of the recent dip has been concentrated in the mortgage category, but there has also been some slowdown in other types of consumer and business borrowing.

Much of the benefit of the sharp fall-off in private credit demands in terms of holding down real rates has been negated by a similar downturn on the saving side.  While the personal saving rate has risen, corporate saving has declined and the pace of foreign capital inflows has slowed.  Of course, after the fact, saving will always equal investment, and borrowing will always equal lending.  Those relationships are accounting identities.  The question is at what price (or interest rate) will the markets clear.  The intersection of government borrowing, private borrowing, domestic saving and foreign inflows will determine where real rates settle in.  As the economy eventually recovers, as the mortgage market normalizes, as foreign central banks diversify and (perhaps most importantly) as the Fed exits, real rates are likely to rise – perhaps significantly – unless the government gets the budget deficit under control.  We suspect that real 10-year Treasury yields might eventually approach the 3.5% level that was seen in the early-to-mid-1990s – a time when government budget deficits were also perceived to be out of control and the Fed was in the process of unwinding a very stimulative monetary policy.  If we factor in an expected inflation rate of 2%, this would imply an equilibrium 10-year note yield of 5.50% or so.

Indeed, some fear that the yield backup reflects out-of-control US budgets and too-easy monetary policy that could create a flight from US assets and increase US risk premiums relative to those abroad.  Such a rise in US risk premiums could frustrate or derail recovery.  Those fears are not unfounded: As discussed below, there’s no way to hide the size of the fiscal stimulus and associated stepped-up supply of Treasury debt.  Nor should market participants ignore the ambitious initiatives and associated funding in the Administration’s just-passed budget.  Regarding monetary policy, the Fed could hardly have been more aggressive in word and deed.  But so far, the yield backup seems to be a global event, rather than a US-centric one.  The very recent rise in rates in Europe, the UK and in other G10 economies, while not in perfect sync with that in the US, has generally kept pace.  That speaks to the globalization of markets, but also suggests a market response to global, rather than simply US developments. 

Finally, inflation uncertainty has risen, boosting the inflation component of Treasury yields.  As evidence, 10-year breakeven inflation rose by about 25bp since the March FOMC meeting to just under 160bp.  While we accept the notion that yields should reflect increased inflation uncertainty, we think markets are overlooking the significant near-term downside risks to inflation.  Market pricing hints that deflation risks are behind us, but we think the analytics of inflation say otherwise and expect that core consumer inflation will head to 1% or less over the next year or so. 

To be sure, rising energy quotes have prevented inflation expectations from declining.  Judging by the University of Michigan’s consumer surveys, longer-term (5-10-year) inflation expectations were roughly stable in April at 2.8%.  But unprecedented slack in the economy poses downside risk to inflation.  Record-low operating rates have promoted a record plunge (31.6% annualized over the last six months) in wholesale intermediate goods inflation.  The housing bust is pressuring rents.  A weak global economy and the lagged effects of a stronger dollar have begun to pressure import prices.  Moreover, an unemployment rate that is heading to 10% should extend the slide in wage growth already evident in both average hourly earnings and the employment cost index.

Given that all three components of the Treasury yield – real yield, inflation component and risk premium – are working to increase yields, it is perhaps testimony to the Fed’s purchasing program that yields have stayed so low.  After all, prior to the recent experience, 3.11% was the record low in 10-year yields.

United States
US Economic and Interest Rate Forecast: Recovery Closer, but Risks Persist
May 13, 2009

By Richard Berner & David Greenlaw | New York

Recovery reflected in the price: Improving economic data have fueled hopes that the recession is ending and recovery is imminent, fueling a sharp rally in risky assets and a sell-off in Treasuries.  Indeed, judging by the recent credit and equity market performance, the systemic downside tail risks for the economy and markets have evaporated, and a virtuous circle between rising markets and an improving economy has taken their place.

US Forecast at a Glance

(Year-over-year percent change)	2008A	2009E	2010E
Real GDP	1.1%	-3.1%	2.0%
Inflation (CPI)	3.8	-0.9	2.3
Core Inflation (CPI)	2.3	1.4	0.9
Unit Labor Costs	0.9	2.3	0.9
After-Tax “Economic” Profits	-6.9	-33.0	12.4
After-Tax “Book” Profits	-14.3	-26.3	16.8

Source: Morgan Stanley Research; E= Morgan Stanley Research estimates

Cyclical risks: We have upgraded our forecast slightly, with the declines in 2Q and 3Q GDP now tracking at -2.5% and -0.5% annualized, compared with -3.5% and -1% last month.  But we’re skeptical that the fundamentals have changed as quickly as markets seem to assume.  While financial conditions are improving and the recession is becoming less intense, we believe that the recovery has yet to emerge, that cyclical headwinds will keep it tepid, and that the risk of declining inflation in the next few months is significant.  As a result, we think risky asset markets are overdone and that in Treasuries some consolidation or a bear market rally is likely (see Bear Market in Treasuries Begins, but Watch for Deflation Risks, May 11, 2009).

How strong is the incipient recovery? Aggressive policies have improved financial conditions and are promoting recovery marginally faster than we anticipated a month ago.  But, in our view, significant risks remain for credit quality, employment, profit margins and state and local outlays, which mean that the recovery will come slowly and likely will be tepid when it arrives.  Critically, that sort of recovery leaves the economy vulnerable to shocks, especially in the context of a global recession.

Financial conditions are improving: There’s ample evidence of improvement: Risk assets have rallied, and volatility has declined, narrowing funding and credit spreads.  Market access and transaction volumes have improved, allowing stressed borrowers to roll over maturing paper.  Mortgage yields have plunged, fostering a refi boom.  The Fed’s Senior Loan Officer Survey indicates that fewer banks have tightened lending standards over the past six months.  Because it is the change in financial conditions that matters most for growth, these factors are all positive at the margin.

Despite the improvement, financial conditions are still restrictive: Home prices are still declining as rising mortgage foreclosures, high inventories and weak demand sustain excess supply, evident in still-high homeowner vacancies.  Commercial real estate values are falling as office and industrial vacancies rise.  Rising unemployment and record-low capacity utilization rates evince large and still-rising prospective credit losses. And lenders’ balance sheets are still encumbered with impaired assets, promoting further deleveraging (see “Credit Losses, Deleveraging and Risks to the Outlook”, Investment Perspectives, May 7, 2009).  Those factors will likely limit the willingness of lenders to make credit sufficiently available to promote a vigorous recovery.  

Credit-sensitive sectors to lag: We think that still-restrictive financial conditions and massive slack in the economy likely will remain headwinds for hiring and capital spending, not just for housing and big-ticket consumer durables, which are the most credit-sensitive sectors.  Companies are restraining hiring to boost productivity and control costs.  Consequently, while the pace of private job loss diminished to 611,000 in April compared with 710,000 in the first three months of the year, losses will still be a significant drag on income through year-end.  Likewise, those factors will weigh on capital spending; the ‘capital exit’ needed to set the stage for improved returns is only beginning (see Capex Bust and Capital Exit, April 20, 2009).  And despite federal assistance and new funds for infrastructure outlays, deteriorating budgets and credit quality are forcing state governments to tighten their belts.

Giving the bull case for recovery its due: Perhaps our fears are overdone; after all, employment and capital spending typically lag a recovery, so they should improve in due course.  Moreover, a sharp inventory cycle – liquidation followed by a snapback – has fueled the start of virtually every post-war recovery, so why should this one be different?  Three metrics suggest that an inventory snapback is less likely this time around.  Inventories aren’t especially lean, as inventory-sales ratios are high.  Likewise, relative to production, liquidation so far has been more limited than commonly perceived.  And the expansion of the global supply chain hints that just as plunging US imports shifted the impact of the sales downturn abroad in recession, an upturn in US demand may boost imports rather than US output.  Moreover, credit restraint may hobble stockbuilding.

Mind the deflation risks: Market pricing hints that deflation risks are behind us; for example, 10-year breakeven inflation has risen to nearly 160bp from less than 1% after the March 18 FOMC meeting.  However, we think the analytics of inflation say otherwise.  To be sure, rising energy quotes have prevented inflation expectations from declining.  Judging by the University of Michigan’s consumer surveys, longer-term (5-10-year) inflation expectations were roughly stable in April at 2.8%.  But unprecedented slack in the economy poses downside risk to inflation.  Record-low operating rates have prompted a record plunge (31.6% annualized over the last six months) in wholesale intermediate goods inflation.  The housing bust is pressuring rents.  A weak global economy and the lagged effects of a stronger dollar have begun to pressure import prices.  Moreover, an unemployment rate that is heading to 10% should extend the slide in wage growth already evident in both average hourly earnings and the employment cost index.  The upshot is that core consumer inflation is likely heading to 1% or less over the next year or so.

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