Morgan StanleyGuneet Dhingr, head of US interest rate strategy, wrote: the Citius,Altius,Fortius-- Olympic motto, translated as faster, higher, stronger, can also be used as our current Treasury yield motto. We believe that the Treasury market will absorb a faster pace of interest rate increases, which is consistent with a stronger economy.
We believe that the yield on the 10-year Treasury note is lower than our reasonable valuation of about 1.60%, in large part because the unwinding of positions in recent weeks has magnified the impact of negative news about the epidemic. In our view, yields do not properly reflect the strong US economy or the position of the Federal Reserve. As the market position becomes clearer, our economists' expectations for strong labour market and inflation data, and the basics of our deficit-backed infrastructure plans, we expect yields to rise in the coming weeks.
To look at Treasury yields, you must first understand why yields have fallen. Our conversations with a large number of investors, as well as the analysis of position data, confirm the important role of positions in exacerbating the decline in yields. The number of open positions in open contracts, or 10-year Treasury futures, fell as yields on 10-year Treasuries fell last month. This tells us that investors are not adding new positions based on a reassessment of the economy or concerns about the Delta variable. Instead, they have been unwinding unprofitable old deals that were meant to yield higher yields.
We think it is important to avoid falling into the trap of forcing down yields, a trap that investors experienced only four months ago:Treasury yields rose sharply in March, mainly as Japanese investors sold Treasuries based on considerations at the end of the fiscal year. However, most investors mistakenly see the rise in yields as proof that the economy is overheating, agreeing that the yield on 10-year Treasuries will break through 2 per cent. We warn investors that yields are already too high relative to economic reality.In the weeks that followed, U. S. economic data failed to keep up with unrealistic expectations, and 10-year Treasury yields began to fall.
Although the lessons of March are vivid, July 2021 looks like the opposite of March. This time, investors are using overly pessimistic terms to lower yields. Many of these narratives do not stand up to scrutiny.
Let's consider the variables. In the UK-this is a reasonable template for the United States, where the number of hospitalizations remains low as cases surge, but the economy reopens and eventually cases begin to decline, suggesting that the downside risks posed by the epidemic have been exaggerated. It is gratifying that Federal Reserve Chairman Colin Powell agreed with this assessment at the FOMC meeting in July.
Another misleading argument is that the market is digesting the Fed's policy mistakes. But this does not match historically low real yields, very high inflation break-even points, or even the strength of risk markets. Some people believe that the decline in the long-term equilibrium interest rate (r *) of the economy is in line with the trend of prices, in terms of economic growth and economic growth.It is strange that inflation is at its highest level in decades. Due to the lack of credible statements to explain the sharp decline in yields and the provable role of positioning, we think we can see a good reason to raise yields from here.
How high can Treasury yields rise? A useful way to consider Treasury yields in the current environment is to link them to the timing of the first rate hike and the pace of rate hikes thereafter:
Currently, the yield on the 10-year Treasury note suggests that the market expects to raise interest rates for the first time in March 2023 and about 1.5 times a year thereafter. We believe that this implied rate increase is too low, especially when people look at the June bitmap, where six FOMC members are expected to raise interest rates three to four times a year (2 members raise interest rates twice a year, 10 members unknown).
Even if we make conservative assumptions about the June chart, the Fed will start raising interest rates by 2-2.5 times in June 2023, a year below the rate shown in the chart. Our analysis shows that the fair value of the 10-year Treasury yield should be around 1.60% today.
What kind of news catalyst will increase the yield? We believe that strong economic data, starting with the July jobs report, which Ellen Zentner, our chief US economist, expects to add just over 1 million jobs, could kick-start a rise in yields. If schools open smoothly in August, it could further boost the strong growth of the job market. In addition, we expect housing inflation to strengthen, which will support the sustainability of inflation. Michael Michael Zezas, our head of public policy, expects a $2,000bn deficit financing plan later this year, which will further boost yields.