If you’re long the 10-year, you’re betting on everything in the world going perfectly — no serious inflation, no macro debt risk — according to latest from Morgan Stanley:
Fed Chairman Bernanke’s speech on Monday could not have
been better tailored to keep bond markets happy. The
commitment to keep policy rates “exceptionally low” for an
“extended period” and the benign outlook for inflation were
both very well received by bond markets, as well as other
risky assets. Obligingly, the Survey of Professional
Forecasters (SPF) showed a drop in both the 1-year ahead
and the 10-year ahead CPI inflation expectations in its 4Q
release. Our proprietary model, MS FAYRE, shows a current
fair value of 3.3% for the US 10-year Treasury yield (see
Exhibit 1) – bang in line with actual yields. Bond markets
seem to be priced for perfection, anticipating that the ‘sweet
spot’ created by exceptionally low policy rates and benign
inflation will remain in place for a long time.
Even if you believe that inflation will play fair, investors seem
to be receiving no compensation at all for the macroeconomic
risks that have surely made an indelible impression over the
last two years, or for the fiscal risks that abound. Finally, such
sanguine expectations in US bond markets put downward
pressure on bond yields elsewhere in the world, making it
difficult for central banks that wish to tighten policy ahead of
the major central banks to gain significant traction through
higher bond yields.
Priced for perfection… MS FAYRE generates its fair value
estimate using the real fed funds rate, 1-year ahead CPI
inflation expectations from the SPF conducted by the
Philadelphia Fed and the 5-year rolling standard deviation of
inflation as a proxy for inflation volatility (for more details on
the MS FAYRE model, see Fairy Tales of the US Bond
Market, July 26, 2006). With the fed funds rate at 12.5bp, core
PCE inflation tracking at 1.3% and the 4Q09 number for
1-year ahead CPI inflation expectations from the SPF coming
in at 1.6%, MS FAYRE produces a fair value of 3.3% for
10-year bond yields, which is exactly where the 10-year yield
is now (interested readers should contact us for a user-
friendly spreadsheet for simulating the FAYRE model).
Forward-looking bond markets thus seem to be pricing in
altogether too rosy a scenario for the foreseeable future.
…for now: With actual bond yields bang in line with our
fundamental fair value estimate, investors seem to be
receiving no compensation for macroeconomic or fiscal risks.
Risk premiums declined precipitously before the Great
Recession and should return to a reasonable level,
particularly in light of the macroeconomic risks that have
made themselves felt over the last couple of years. Further,
with the bulk of the approved fiscal package in the US yet to
be spent, the successful handling and eventual retirement of
debt seems very far away with plenty of risks along the way.
Bond markets have clearly not turned their attention to these
issues yet, but it is unlikely that they will ignore them forever.