So It Begins - Part 2

Morgan Stanley Sees 5.5% Note as U.S. Faces Deficits (Update2)

By Oliver Biggadike and Daniel Kruger

Dec. 28 (Bloomberg) -- If Morgan Stanley is right, the best sale of U.S. Treasuries for 2010 may be the short sale.

Yields on benchmark 10-year notes will climb about 40 percent to 5.5 percent, the biggest annual increase since 1999, according to David Greenlaw, chief fixed-income economist at Morgan Stanley in New York. The surge will push interest rates on 30-year fixed mortgages to 7.5 percent to 8 percent, almost the highest in a decade, Greenlaw said.

Investors are demanding higher returns on government debt, boosting rates this month by the most since January, on concern President Barack Obama’s attempt to revive economic growth with record spending will keep the deficit at $1 trillion. Rising borrowing costs risk jeopardizing a recovery from a plunge in the residential mortgage market that led to the worst global recession in six decades.

“When you take these kinds of aggressive policy actions to prevent a depression, you have to clean up after yourself,” Greenlaw said in a telephone interview. “Market signals will ultimately spur some policy action but I’m not naive enough to think it will be a very pleasant environment.”

Yields on the 3.375 percent notes maturing in November 2019 climbed 4 basis points to 3.84 percent at 11 a.m. in London today, according to BGCantor Market Data. The price fell 10/32 to 96 5/32. They have risen 65 basis points this month, the most since April 2004, as government efforts to unfreeze global credit markets lessened the appeal of the securities as a haven.

Treasury Futures

Speculators, including hedge-fund managers, increased bets that 10-year note futures would decline more than fivefold in the week ending Dec. 15, according to U.S. Commodity Futures Trading Commission data. Speculative short positions, or bets prices will fall, outnumbered long positions by 52,781 contracts on the Chicago Board of Trade. It was the biggest increase since October 2008.

In a short sale, investors borrow securities and sell them hoping to profit by repurchasing the securities later at a lower price and returning them to the holder.

Ten-year notes will end 2010 at 3.97 percent, according to the average of 60 estimates in a Bloomberg News survey that gives greater weight to the most-recent forecasts.

Edward McKelvey, senior economist in New York at Goldman Sachs Group Inc., the top-ranked U.S. economic forecasters in 2009, according to data compiled by Bloomberg, expects yields to drop to 3.25 percent. Goldman Sachs says unemployment will average 10.3 percent in 2010, hindering the recovery.

Treasury’s Competition

The U.S. will face increased competition from other debt issuers, spurring investors to demand higher yields as the Federal Reserve ends a $1.6 trillion asset-purchase program, according to James Caron, head of U.S. interest-rate strategy in New York at Morgan Stanley. The central bank was the largest purchaser of Treasuries in 2009 through a $300 billion buyback of the securities completed in October.

The Treasury will sell a record $2.55 trillion of notes and bonds in 2010, an increase of about $700 billion, or 38 percent, from this year, Morgan Stanley estimates. Caron says total dollar-denominated debt issuance will rise by $2.2 trillion in the next 12 months as corporate and municipal debt sales climb.

Mortgage Rates Rise

Mortgage rates last reached 7.5 percent in 2000 as productivity gains slowed after the demise of some Internet companies. The average rate on a typical 30-year fixed-rate mortgage climbed to 5.05 percent in the week ended Dec. 24, according to McLean, Virginia-based Freddie Mac.

Yields on mortgage securities issued by Fannie Mae rose to a four-month high of 4.54 percent last week. Fannie and Freddie securities are used to guide borrowing costs on almost all new U.S. home lending.

Higher borrowing costs as the U.S. shows signs of beginning to emerge from the longest economic contraction since the 1930s puts Treasury Secretary Timothy Geithner in a situation similar to one faced by his predecessor Robert Rubin.

Greenlaw says the U.S. will probably have to offer investors such as foreign central banks and mutual funds real returns of more than 3 percent for 10-year notes to attract funding.

Deficit Spending

“There’s no free lunch, and when you take these kinds of aggressive policy actions to prevent a depression, you have to clean up after yourself,” Greenlaw said. “Foreign central banks are just not going to be able to finance these kinds of budget deficits for very long.”

Monetary officials in China, Japan and other countries helped Geithner lower U.S. borrowing costs by 15 percent in the government’s 2009 fiscal year. Indirect bidders, a group of investors that includes foreign central banks, purchased 45 percent of the $1.917 trillion in U.S. notes and bonds sold this year through Nov. 25, compared with 29 percent a year ago, according to Fed auction data compiled by Bloomberg News.

The decline in interest expense was the biggest decrease since before 1989 and came even as the nation’s debt increased by $1.38 trillion this year to $7.17 trillion in November, the data show.

“Could one imagine the market for debt being saturated? Of course,” said Lawrence Summers, director of the National Economic Council, speaking in New York on Oct. 8. “We will not, as a country, as the economy recovers, be in a position to issue federal debt on anything like the scale that was appropriate to issue federal debt during a profound economic downturn.”

Jenni LeCompte, a Treasury spokeswoman in Washington, declined to comment on higher borrowing costs.

Morgan Stanley’s Caron predicts the spread between 2-and 10-year yields will rise to 3.25 percentage points next year.

“There is a lot of supply coming to the markets next year,” Caron said. “In 2009 there was a lot of support for that supply. The question going forward is what happens when there is not.”

 Comments:

 In a post back in October (So It Begins) we noted that the rise in interest rates was inevitable as massive government borrowing started to push rates up.  Many economists, including David Greenlaw, chief fixed-income economist at Morgan Stanley, justify the largess of extreme borrowing and spending by telling us that they had "prevented a depression".  However, just because Keynesian economists believe a depression has been averted, does not mean we have dodged the bullet.  In my view, we have only delayed the depression by perhaps a year or so.
Consider the following indicators:
10 year note yields rising 65 basis points in 1 month.
Baltic Dry Index with a reading of 3005, remains at low levels compared to the reading of 9143 two years ago. 
U3 Unemployment is over 10% with U6 "real unemployment" over 17%
Okun's law dictates that unless the economy grows more than 3%, unemployment does not drop.
World trade remains 20% below peak levels, and world industrial production is 10% off the peak.  (See www.voxeu.org for details.)
A substantial number of ARMS are due to reset and recast in late in 2010 and 2011 in a higher interest rate environment. (see chart below courtesy of the Daily Reckoning)

These indicators are telling us something quite different than the media is reporting from Washington and New York.

The last indicator is particularly concerning.
If the Fed and Treasury are unsuccessful in their attempt to keep long term mortgage interest rates low, an increase from 5% rates to 8% rates has a huge impact on house and commercial property values.

As an example, consider a house with a $150,000 mortgage:

5% rate with 30 year amortization = monthly payment of $  805.23
8% rate with 30 year amortization = monthly payment of $1100.65

An increase in payment amount of 36.7% will sink many home and commercial property owners.
Net result - House and commercial property values will continue to fall since capitalization rates will increase.

This is highly deflationary and particularly bad timing given the large number of mortgage resets coming in the next 24 months..