What Would Cause A 5.50% 10-Year Note Next Year?

  • Bloomberg.com – Morgan Stanley Sees 5.5% Note as U.S. Faces Deficits
    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. … 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.


The story above says a 5.50% 10-year yield would be the “the biggest annual increase since 1999, according to David Greenlaw, chief fixed-income economist at Morgan Stanley in New York.“  We are not sure what he means by this.  If he means a rise in yields from 3.84% (current) to 5.50% would be a 166 (basis points) bps rise in yields, the largest since 1999, technically he is correct.  However, the 10-year started the year at 2.24% and has risen 160 bps already year-to-date.  Should the 10-year yield rise another three bps this week, then a rise to 5.50% next year would be smaller than this year’s increase in yields.  Morgan Stanley is trying to get our attention with an eye-popping statistic to get the point across that next year will be a bad year for Treasury market investors.

We bring this up not to be picky, but to point out that 2009 is going to be long-term Treasury securities’ worst total return year ever.  Year-to-date (YTD) the 10-year is down 10.2% (the 30-year is down an incredible 24% YTD).  These are by far the worst total returns ever seen in the fixed-income market for one year.  Reliable data started in 1927.

If Morgan Stanley is trying to say that 2010 will be a disaster for Treasury investors, here is some news for them, 2009 was a disaster in proportions never before seen.  So, are they looking at what has happened and projecting that it will happen again?

What Do We Think?

The chart below shows the last decade of 10-year yields.  A move to 5.50% (gray horizontal line) would be near a 10-year high.

<Click on chart for larger image>

We believe that such a move is entirely possible on the back of runaway inflation fears.  The next chart below shows TIPS 10-year inflation breakeven levels.  Note that in recent weeks inflation expectations have been going vertical and are now at 2.40%.

<Click on chart for larger image>

Inflation expectations are up almost 250 bps since the start of the year, far more than the 160 bps rise in nominal 10-year yields.   Should 10-year yields go to 5.50% by the end of next year, we would expect it to be accompanied by a huge rise in inflation expectations.  Back-of-the-envelope calculations would put the 10-year inflation breakeven rate near 4.00%, an all-time high (its current record high, which is not shown above, was 3.32% set the week after TIPS were first introduced in February 1997).

In other words, a rise to 5.50% would mean that TIME’s Person of the Year (Bernanke) was an utter failure in 2010, as is often the case the year after one is awarded POY.  The exit strategy will have been botched and the world will be close to hyperventilating about inflation coming back.  Julian Robertson’s prediction of 20% inflation will not look so laughable anymore.

This scenario is certainly possible if the Federal Reserve continues to flood the market with easy money, thus fueling inflation fears.  In other words, this can happen if the Federal Reserve continues to botch the exit strategy (not botching the exit strategy means to withdraw the excess liquidity before heightened inflation expectations take hold and without causing financial market instability) .  Higher inflation is something we have frequently worried about and we believe is the foundation of Morgan Stanley’s forecast.

Of course Morgan Stanley cannot say this out loud because they need access to the Federal Reserve.  The Fed comes down very hard on mainstream forecasters that say anything bad about them.

Category: Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

13 Responses to “What Would Cause a 5.50% 10-Year Note Next Year?”

  1. Steve Barry says:

    Why do higher yields have to signal inflation? If credit quality deteriorates, due to excessive debt, yields will go up (bond prices down). Don’t we have to issue at least 2 Trillion in paper next year? Thinking that only inflation can cause the rate to rise is being a brainwash victim of the Fed Error, er, Era.

    What is going to happen to munis as states beg for bailouts?

  2. Steve Barry says:

    And Peter Boockvar makes a good point in MacroNotes:

    “The credit markets led the way down in ‘08 in terms of equity performance, up in ‘09 and I believe will again dictate the direction in ‘10, particularly the sovereign side, which now includes half of the entire mortgage debt in the US. “

  3. [...] slide … Ritholtz squad just put some thinking to MSs estimate and we thought it was worth noting, linking to and having so as we can refer back to it next year … At the end of the day, if you think the [...]

  4. Steve Barry says:

    And another support to my argument:

    “Last year (2009) there was almost no net debt issuance between corporates and Treasuries, adjusted for Quantitative Easing. Indeed, it was only about $200 billion. That this sort of extreme measure was required to prevent a bond market implosion is rather telling. But what’s worse is what’s on the calendar for 2010 – nearly $2 trillion of net issue, duration-adjusted. A huge part of this is Treasury debt, and there the news is even worse, as there’s a serious duration problem in this regard – nearly half (about 40%) has a maturity of one year or less. This means that Treasury must roll over that debt – about $3 trillion worth – “or else.”

    Ask the asset-backed commercial paper market and auction-rate securities folks what happened to them when their short-duration paper couldn’t be rolled on commercially-reasonable terms. Then extrapolate that to what happens to Treasury if (or possibly when) they’re unable to roll $3 trillion plus issue another $2 trillion on top of it to fund the deficit.”


    So what could cause a 5.50% yield? A better question is how will it be prevented.

  5. moruobai says:

    “In other words, a rise to 5.50% would mean that TIME’s Person of the Year (Bernanke) was an utter failure in 2010, as is often the case the year after one is awarded POY.”

    I think that statement has it totally backwards. Bernanke spent his life studying the Great Depression and concluded that to prevent a second one from occuring he 1) couldn’t let the banks fail and 2) had to keep the money supply from collapsing. He’s given several speeches about “making sure deflation doesn’t happen in the US” and he has often referenced his “electronic printing press”. This guy was born to be in the position he is currently in.

    Generating inflation is the whole point of the Fed’s (and Treasury’s) actions. They are trying their damndest to reflate the housing market (and the stock market!) so consumers don’t default owing to negative equity and banks don’t have to take the writedown. If yields on the 10-year reach 5.5% this will mean Bernanke has succeeded, not failed. This will mean Bernanke beat deflation. Put it another way, rock bottom yields are what Japan has achieved.

    I know I personally feel a lot better with yields at their current level than I did when yields were testing the 1 handle a few months ago!!

  6. par1 says:

    Isn’t the fact that 95% of the Bloomberg article focuses on the MS forecast of 5.5% rates, while devoting only three lines and no analysis to the Goldman Sachs forecast of a 3.25% 10-year, in itself a contrarian indicator suggesting that perhaps GS is more on target in its analysis? But heck, what do the guys at GS know….or if we’re going to be conspiratorial, what do they *really* know but are telling only their proprietary traders and best clients?

    Also, talking about how bad 2009 was for bonds is a little meaningless without the context of late 2008, when rates fell off a cliff. Net net, rates are back to where they’ve spent most of the last two years.

  7. Steve Barry says:


    Maybe both are wrong and rates are going to 7%…but MS would be less wrong.

  8. CTB says:

    I don’t see a rates shooting up because of a lack of credibility. What other options do people have? Stuffing money under the mattress? None of the other major currencies are looking particularly good.

  9. stevenstevo says:

    Inflation is coming. Only question is how bad will it be. Bernanke is screwed no matter what: he had nothing to do with causing this crisis obviously, but he will still go down with plenty of blame. What is more, the Fed gets none of the blame for causing the crisis–it was all the greedy bankers’ fault. And then even on top of all this, what Big Ben did do was try to stop the devastating crash–he takes action and low and behold, we have a recovery and a year later, the markets are up big in 2009. Now, he may not deserve all the credit for this, and his loose monetary policy may provide to do more harm than good, but consider: unless we end up with the magical medium and hit that 2.5% modest inflation over the next decade, he will be considered a failure. If there is deflation or too much inflation, failure. On top of all this, if inflation does hit 20% like Julian says is a real possibility, then surely a large contributing factor was excessive government spending driven by the health care plan and what not. I guess one could make the argument that Ben should not have been so loose with the money because he should have anticipated how much money our federal government would start spending all over the placed on stuff like health care. The problem is it will be impossible to know ten years from now: would inflation have remained modest had we not passed a trillion dollar health care bill?

  10. I still don’t see what would stop Bernanke, Time’s Person of the Year*, from buying those Treasuries and getting other CBs to do likewise in order to prevent the crash in treasury prices. After all this is a confidence game and the Fed has taken on the job of maintaining that confidence

    *I think every time we refer to Bernanke we should refer to his award.

  11. Jim Bianco says:


    You’re right that a credit problem would cause interest rates to rise. But that would cause ALL interest rates to rise. Specifically, the yield curve would flatten as 40% of Government debt matures in the next year. It would cause all forms of Government debt, like TIPS and Federal Agency debt to rise in yield. It would cause “Build America” bonds to rise in yield (as they have a guarantee from the Federal Government). etc.

    However, this is NOT what we are seeing. Demand for short Treasuries is booming. Last week’s T-Bill auction drew a record bid-to-cover ratio of 6:1. The yield curve is steepening and Agency and Build America bonds maintain their tight spread to Treasuries.

    When you drill down you see that long-term interest rates are rising, not short-term (steepening yield curve) and TIPS are outperforming Treasuries (meaning implied inflation rates are growing). All of this is consistent with heightened inflation expectations.

    moruobai :

    Milton Friedman was correct when he said that inflation is “too much money chasing too few goods.” Those that argue that inflation is under control because of excess capacity in the system do not understand how it works. It’s all about money.

    The reason inflation has not come back (yet) is the transmission mechanism of all this money, the banking system, has been dysfunctional. Now that it on the verge of healing (or has healed) the market sense that all this money will not create inflation, despite what plans Bernanke has to withdraw the liquidity. This is why the markets are signaling inflation’s return. They see it coming.

    Yes, you care correct, the Fed has been trying to reflate and their efforts are about to be successful. My fear, and I believe the market’s fear, is we are about to see the full burnt of reflationary policies take hold. What you are assuming is that inflation is going to be spread about equally. If the inflation rate (headline CPI) spikes to say 7%, that wages will go up 7%, stocks will tack an extra 7% on their returns, banks will increase borrowing rates by 7% and so on. It does not work that way. Wages and returns will lag behind inflation and everyone loses. Banks will see their delinquency rate decline but will get paid back in depreciated money. They will be net losers.

    Bottom line, saying inflation’s return is a good think is like say the junkie in the corner having convulsion and puking blood is good as he is getting the drugs out of his system. In a VERY narrow technical sense you’re correct but you’re going to absolutely hate being correct on this one.

  12. Greg0658 says:

    sso :-| it’s always butters fault never guns
    people who know me know I’m being facecious

    and Jim & Milton – “too much money chasing too few goods” .. I think there is another inflation side – human spirit to hang on & make payments for the family .. there is a power in hands & feet (still)

  13. AllStreets says:

    A world with 5.5% 10-yr T-notes would provide a very interesting year and checkmate for the housing problems. 5.5% implies 6%+ 30-yr fixed mortgage rates and rising ARM adjusted rates (adjusted ARM rates are now only about 2.75%), but most likely a still sharply positive yield curve. So most refis and many purchases would be with ARMs, possibly a dangerous prospect for the longer term with 20% prospective inflation. But both purchases and refis would be down sharply. With 14% of mortgages in default, 30% underwater, and 17% under/unemployment with poor near term prospects for rescue, the foregoing interest rate trends would certainly cause another major collapse of housing prices due to massive portions of the citizenry entering foreclosure and/or bankruptcy. It should be noted that the latest salvo of economic reform from mortgage “investors” changed the minimum credit score for government insured loans from 620 to 640, thereby eliminating yet another 7% of the citizenry from consideration. Even with 3% mortgage rates, I don’t see any prospect whatever that inflation can rise enough to rescue housing or employment rise enough to reverse the rising tide of foreclosures, so maybe it doesn’t matter what interest rates do…checkmate. If inflation is the watchword for 2010, are we going to see $4 gas again? Inflation in addition to higher interest rates would certainly be the final fatal push to the 30 million or so Americans who are teetering on the brink of bankruptcy and homelessness. And what are all these foreclosures and bankruptcies going to do to the lenders? Were drastic enough assumptions in the stress tests? I doubt it very much. If ending QE and Treasury purchases is the coming program for the Fed to save its own skin, and that will jack rates, it might destroy the banks as well as the body politic.