Morgan Stanley says this key factor could keep global bond yields in check, but markets disagree

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  • Morgan Stanley forecasts benchmark US 10-year bond yields will fall to 2.75% by the end of 2018.
  • Although the US Fed is reducing the size of its balance sheet, MS says that process will end sooner than the market is forecasting.

Markets shouldn’t expect a sharp rise in US bond yields anytime soon, according to analysts at Morgan Stanley.

MS said that while the Fed has been steadily reducing the size of its balance sheet after years of monetary stimulus, the reduction is likely to be smaller — and will conclude sooner — than many in the market currently expect.

Despite that, the analysts still expect financial conditions to tighten into 2019. They suggested buying US treasuries, with an underweight position in US corporate bonds.

The bank forecasts that US 10-year bond yields — the global benchmark — will fall to 2.75% by the end of this year, before declining to 2.5% in 2019. US 10-year yields closed overnight at 2.849%.

In making their call, the analysts noted their view puts them at odds with primary dealers and other bond market participants.

At the core of their argument is the effective federal funds rate (EFFR).

“To keep the fed funds rate within its target range, we project the Fed will need to end balance sheet normalization in September 2019 — earlier than the market expects,” Morgan Stanley said.

US commercial banks are required to hold a minimum amount of deposits with the Federal Reserve, and the EFFR is the rate at which they lend to each other on overnight terms in order to maintain their reserve requirements. So the EFFR can be viewed as a gauge of short-term liquidity in the US financial system.

The Fed’s target range for the EFFR is 25 basis points (0.25%). Morgan Stanley expects the central bank will conduct policy so as to keep the EFFR well within that range, by maintaining asset reserves in excess of commercial banks’ minimum deposit requirements.

To achieve that, MS expects the Fed to remain active in the open market via its System Open Market Account (SOMA) portfolio, comprised largely of US treasuries and foreign assets denominated in either euros or the Japanese yen.

“We expect the SOMA portfolio to be just above $US3.8 trillion at the end of 2020,” Morgan Stanley said. “In contrast, primary dealers place a 68% probability that the SOMA will be smaller than $US3.5 trillion at the end of 2020.”

The analysts said they expect the Fed to provide a more detailed discussion about the size of its balance sheet at its December meeting. (Currently, CME’s Fedwatch tool is assigning a 52.9% probability that the Fed will raise rates at its December meeting, which will complete a cycle of four rate hikes in the 2018 calendar year).

Looking ahead to 2020, the analysts ruled out any aggressive actions by the Fed in reducing the size of its balance sheet.

“We expect the Fed to roll over its Treasury securities at auction consistent with current practice, and grow its balance sheet via permanent open market operations across the Treasury curve in 2020,” the analyst said.

With US 10-year yields falling to 2.5%, Morgan Stanley expects the yield spread between 2-year and 10-years to turn negative, resulting in an inverted yield curve by mid-2019. Based on overnight closing rates, the current 2-10 spread is around 26 basis basis points.

Global central banks are increasingly signalling towards a gradual tightening in monetary policy, after years of record monetary stimulus.

The US Fed is further along that path than most, steadily raising rates and reducing the size of its balance sheet as the economy strengthens.

It’s led some market participants to speculate about potential negative consequences for the global economy,

However, Morgan Stanley’s forecasts indicate that although the US Fed is tightening policy, the pace of that transition is likely to remain gradual.

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