MORGAN
NORTH
STANLEY
RESEARCH
AMERICA
US Economics Team
Morgan Stanley & Co. Incorporated
Richard Berner
Richard.Berner@morganstanley.com
David Greenlaw
David.Greenlaw@morganstanley.com
Ted Wieseman
May 10, 2010
Ted.Wieseman@morganstanley.com
David Cho
US Economics
Sovereign Credit Risk Means
a Lower Path for US Rates
Fed on hold through year-end, lower path for yields.
We now expect that the Fed will be on hold until early in
2011; previously we thought that they would begin to
raise rates in September. We also now see a lower path
for 10-year US Treasury yields through 2011; we expect
yields will rise from today’s 3½% to 4½% by the end of
2010, 100 bp lower than our previous forecast.
David.Cho@morganstanley.com
Recent Reports
Global Rebalancing Favors US Net
Exports
Richard Berner
April 28, 2010
Don’t be Sidetracked by the Inflation
Measurement Debate
Richard Berner
April 15, 2010
Business Conditions: Ongoing Recovery
Richard Berner & David Cho
April 9, 2010
:
Contagion risk is the driving force for rates… The
European sovereign credit crisis has capped inflation
expectations, and it could reverse some of the
significant improvement in financial conditions that has
revived US growth. Although aggressive action by
European officials to stem the crisis likely will reduce the
tail risks of contagion, uncertainty remains high.
…but only a limited brake on US growth. Credit
contagion won’t materially slow US growth, in our view,
as US domestic fundamentals are now taking over from
global support. Combined with lower US rates, changes
in foreclosure mitigation policy, and extended tax cuts,
domestic strength is prompting us to revise our forecasts
for US real growth somewhat higher: from 3.2% to 3½%
over the four quarters of 2010, and from 2½% to 3% for
2011.
Delaying tightening now gives the Fed more work to
do. We think the Fed will raise the funds rate to 2½% by
the end of next year, yet even that increase seems likely
to put real short-term rates barely in positive territory.
And while the yield curve likely will flatten after 2010, we
expect another 50 bp rise in 10-year yields to 5% in
2011.
For important disclosures, refer to the
Disclosures Section, located at the end of
this report.
MORGAN
STANLEY
RESEARCH
May 10, 2010
US Economics
Sovereign Credit Risk Means a Lower Path for US Rates
Richard Berner & David Greenlaw (New York)
Exhibit 1
Sovereign Debt Contagion Has Crushed Inflation
Breakevens
Fed on hold through year-end, lower path for yields. We
are changing our long-standing calls for US interest rates: We
now expect the Fed to keep policy on hold until early in 2011;
previously we thought the Fed would begin to raise rates in
September. And we see a significantly lower path for 10-year
US Treasury yields through the end of 2010: We now think
10-year yields will rise from today’s 3.6% to 4½% by year-end
— that’s 100 bp lower than the 5½% level we previously
expected.
These changes imply dramatic, cyclical changes in the yield
curve over 2010-11. With the Fed on hold, we expect the yield
curve will steepen further this year, as we still see a significant
rise in real yields, reflecting heavy Treasury borrowing and the
pickup in private credit demands that will accompany an
improving economy. In contrast, we expect a significant
flattening of the yield curve in 2011, as the Fed tightens
aggressively and 10-year yields move to 5%.
Contagion risk is the driving force for rates… The
European sovereign credit crisis, its threat of contagion beyond
Europe, and its effect on inflation expectations is the key
reason for these significant changes. The primary
transmission channel for such contagion is via interbank
funding markets, as rising concerns about credit quality prompt
banks to pull back from unsecured lending on attractive terms.
By raising risk premiums more broadly, the crisis could reverse
some of the significant improvement in financial conditions that
has revived US growth. The crisis promoted a flight to quality
into US Treasuries and has capped inflation expectations.
While our European economics team anticipated and
documented the crisis, we did not anticipate how quickly the
fears of contagion could spread to US markets. 1
1
Our European team long ago identified the crisis as one of solvency,
400
Basis Points
360
320
5y5y BEI Fed Measure
280
240
5y5y BEI Market Measure
200
160
120
80
40
Feb-05 Aug-05 Feb-06 Aug-06 Feb-07 Aug-07 Feb-08 Aug-08 Feb-09 Aug-09 Feb-10
Source: Federal Reserve Board, Macroeconomic Advisers, Haver Analytics
…but only a limited brake on US growth. The threat of
contagion from the sovereign credit crisis does pose a clear
downside risk to our sustainable growth scenario, and with
inflation low, gives the Fed ample reason to wait and make sure
this risk is limited. We believe that the spillover to US growth
will be muted, as contagion will mainly affect European banks,
credit availability in Europe, and European growth. Most
important, European policymakers are adopting aggressive
steps collectively to ring fence the effects of the crisis, limiting
the tail risk of a more intense and persistent freezing up of
global liquidity and worsening in global risk aversion. 2 Barring
such tail risks, the further impact of any deterioration in an
already limp European economic outlook on the US in our view
will be limited. 3
Déjà vu 2007-8? No, it’s 1997-8 all over again. Following an
intense week of market meltdowns and fears that domestic and
trade finance will dry up as it did three years ago, our
conclusion may seem counter-intuitive. However, we believe
that US monetary and fiscal policies are still supportive of
growth. So the outcome seems likely to parallel the 1997-98
2
For details, see Elga Bartsch and Daniele Antonucci, “Fast-Track to
not liquidity; that solving it would require making tough choices and
Fiscal Union,” May 10, 2010.
enormous resources; and that the main issue was whether contagion
3
would spread from the periphery to the core countries. See Elga
slowdown in European growth might shave 0.2% from that in the US.
Bartsch, et al, “Whither Greece,” January 25, 2010; “Greece and EMU:
Three channels matter: exports, earnings and financial linkages.
Between a Rock and a Hard Place,” February 22, 2010; “Quick
Europe broadly defined accounts for about 23% of our exports, 8% of
Comment: Our First Assessment of Greece’s Loan and Austerity
S&P revenues, and 4.1% of US banks’ total assets. See “A European
Package,” May 2, 2010.
Slowdown Would Only Nick the US,” February 12, 2010.
In February, for example, we argued that a one-percentage-point
2
MORGAN
STANLEY
RESEARCH
May 10, 2010
US Economics
Asian financial crisis, when stimulative policy more than offset
any fallout from the Asian meltdown on US and global growth.
Some might argue that the US economy was much more
resilient in 1997-8 than it is today, because it was growing
strongly back then and did not face today’s headwinds from the
2007-9 financial crisis. Numerically, that is true, but today’s
resilience is high and rising in our view.
The real handoff: From global to domestic strength. That’s
because classic, cyclical tailwinds of recovery are winning the
tug of war with secular headwinds hobbling growth. Those
tailwinds reflect an important shift — from reliance on the
strength of global growth to domestic forces of output,
employment and income gains that make recoveries
self-sustaining. In addition, reduced tail risks from mortgage
foreclosures and a likely extension of tax cuts for most
consumers in 2011 will reinforce that improvement.
in US output this year, in contrast with the typical drag on US
GDP as imports rebound in recovery. 4
Financial conditions remain supportive. While observers
glued to their screens legitimately worried whether the slide in
markets will hobble growth, we think that on balance, financial
conditions remain supportive. For example, the Fed’s April
Senior Loan Officer Survey showed continued improvement,
with further easing of lending standards for business loans and
a rising willingness to make consumer loans. Notably, a net
14.0% of respondents said they were more willing to extend
consumer installment loans (with focus on credit cards), the
highest level in four years. The cost of business credit also
eased, with a net 7.1% of respondents saying that they had
reduced the spread of loan rates over the cost of funds for large
companies, the first decline in the spread since 2007.
Exhibit 3
The upshot: We are revising our forecasts for US real growth
somewhat higher both this year and next; from 3.2% to 3½%
over the four quarters of 2010, and from 2½% to 3% over the
four quarters of 2011. But for the tail risk from sovereign credit
contagion, we would likely make more significant upward
revisions to our outlook.
Credit Availability Normalizing
80
Percent
Net percentage of
domestic respondents
tightening standards
on consumer loans:
other consumer loans
60
40
20
Exhibit 2
Global Growth Still a Driving Force for US Output
20
0
65
-20
Banks willingness to
lend to consumers
15
60
-40
10
5
55
-60
87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10
0
50
ISM Manufacturing:
New Export Orders
Index (Right Scale)
-5
-10
45
-15
Real Exports, f.a.s.
(Year-over-Year Percent
Change, Left Scale)
-20
40
-25
35
97
98
99
00
01
02
03
04
05
06
07
08
09
10
Source: Census Bureau, Institute for Supply Management
Global growth remains strong. Growth abroad remains a
driving force for the US economy. Despite the spreading
European sovereign credit crisis, global growth is likely to be
even stronger than the 4.4% we expected in March. Domestic
demand in the fast-growing economies of Asia, Latin America
and Canada is driving their expansion, and US exporters will
be increasingly leveraged to that rapidly-growing pie. As a
result, we think US (net) exports will add about 0.3% to growth
Source: Federal Reserve Board
To be sure, market pricing deteriorated dramatically last week,
and markets are tender. Most obviously, risk markets plunged
and volatility soared. The aggressive financial stabilization
package announced overnight has reversed some of those
moves. In addition, however, precautionary demands for
liquidity pressured LIBOR and other funding spreads over
expected policy rates, echoing the experience in August 2007.
Three-month LIBOR surged 8 bp on the week to 0.428%, and
as the path of policy rates was marked lower, forward
LIBOR/OIS spreads widened, with June surging to 38 bp,
September to 40 bp, and December to 42 bp. If continued, the
risk is that such developments would tighten financial
conditions.
4
See “Global Rebalancing Favors US Net Exports,” April 28, 2010.
3
MORGAN
STANLEY
RESEARCH
May 10, 2010
US Economics
But even with those risks, the lower trajectory we now assume
for US risk-free interest rates across the maturity spectrum
means that wider corporate and mortgage spreads should
leave business and household funding costs basically
unchanged. For example, with current-coupon mortgage
yields falling well below 4.5%, 30-year mortgage rates are set
to drop below 5% soon. And the long-awaited pickup in credit
demands has in fact begun, with nonfinancial commercial
paper issuance up $35 billion and consumer credit stabilizing
since the start of the year.
US incoming data mostly stronger. Incoming data mirror
that strength: Indicators of consumer and business equipment
spending are beating expectations, although an uncertain
policy environment has depressed sentiment. Leading
indicators of US export demand are at 21-year highs, while
inventories are growing leaner. To be sure, housing
imbalances are only shrinking slowly, and labor markets are
strengthening gradually, but they are both improving relative to
our bearish view on housing and our cautious employment
outlook. Homeowner and rental vacancy rates edged lower in
the first quarter.
Most important, the rise in private nonfarm payrolls has
accelerated sharply to an average 156,000 in the past three
months, and the workweek continues to rise. We estimate that
nonfarm hours worked will rise by 3% annualized in Q2, the
strongest pace in four years. Judging by the 276,000 average
employment increase in the three months ended in April, as
measured in the household survey (adjusted to be comparable
with payrolls), along with the recent pickup in Federal
government withheld tax collections, further acceleration
seems imminent. We estimate that real, after-tax wage and
salary income will run at a hearty 4% clip in the first half of
2010.
Policy changes to mitigate foreclosures. Two policy
changes – a new “earned principal forgiveness” initiative in
HAMP (Home Affordable Modification Program) and the short
refinance program through the FHA – will reduce the downside
tail risks to home prices and housing. If implemented
effectively, these changes will help reduce the “shadow
inventory” of yet-to-be foreclosed homes and the likelihood of
strategic defaults, and should help restart the normal flow of
housing credit. 5 Still, these proposals will not magically solve
our housing problems. 6 Accordingly, our forecast for US
housing starts in 2011 continues to be pessimistic, the lowest
of any in the Blue Chip survey of economic forecasts.
Tax breaks for consumers. Reflecting the pressing need to
get started on reducing massive Federal deficits, we previously
assumed that the Administration would sunset the Bush tax
cuts and increase the tax rate on dividends and capital gains
on January 1, 2011, resulting in roughly a $120 billion tax hike
for individuals. 7 In contrast, we now assume, as did President
Obama in his FY 2011 budget, that the individual income tax
cuts begun under EGTRRA and JGTRRA will be extended on
December 31 for lower- and middle-income taxpayers. That
adds half a percentage point to 2011 growth relative to our prior
baseline.
Financial linkages to Europe pose the biggest risk. Rising
risk premiums in European markets, especially for banks and in
bank funding markets, pose the biggest risk to US financial
conditions. However, US financial exposure to Europe is
relatively low: For example, US banks’ claims on residents of
the European periphery were a miniscule 0.3% of total assets
as of 4Q09, and claims on all European residents amounted to
only 4.1% of total assets. Claims on the UK comprise the vast
majority of that (3.0% of assets), while claims on other
European countries represent the remaining 1.1%. 8 As we
learned in the financial crisis, however, such linkages could
become extremely important if idiosyncratic risk morphs into
something systemic.
Delaying tightening now gives the Fed more work to do in
2011. The slightly stronger US growth trajectory we now see
through 2011 paints a different picture for monetary policy and
long-term yields next year. With narrower slack in the economy,
downside inflation risks will be smaller than before. Also, as
our rate strategist Jim Caron notes, the sovereign credit turmoil
has stemmed the risk of unwinding or hedging overcrowded
long bond positions for now. But in the wake of a strengthening
economy, those technical factors still have the potential to drive
yields sharply higher. Sovereign risks have also recently
depressed forward inflation breakevens, and we expect those
6
See “Assessing Housing Risks,” November 30, 2009 and “ABS
Market Insights: Understanding Strategic Defaults,” April 29, 2010.
7
The Congressional Budget Office estimates that extending the Bush
tax cuts would boost the deficit by $115 billion in FY 2011, and raising
the top rates on capital gains and dividends would boost it by another
$5 billion in that fiscal year. See The Budget and Economic Outlook:
5
For more detail, see Vishwanath Tirupattur and James Egan, “ABS
Fiscal Years 2010 to 2020, January 2010.
Market Insights: Forgive and Forget,” March 29, 2010. Much of the
8
commentary on housing is based on their analysis.
2010.
See Betsy Graseck, “US Bank Direct Exposure to EU is Low,” May 5,
4
MORGAN
STANLEY
RESEARCH
May 10, 2010
US Economics
declines to reverse over the next several months as stronger
US fundamentals outweigh those concerns. With a later start
to tightening, the Fed will have more work to do: We think the
Fed will raise the funds rate to 2½% by the end of next year.
And even that increase seems likely to put real short-term rates
barely in positive territory.
Real yields are likely to remain high in 2011. One set of
factors relates to our story of supply and demand in the credit
markets: Treasury borrowing needs, especially in coupon
securities, will remain high. 9 We expect that the incipient
pickup in private credit demands, meanwhile, will mature into a
steady flow, reflecting stronger demands for business and
consumer credit-sensitive demands, such as capex and
inventories. Thus, while the yield curve likely will flatten, we
expect 10-year yields to climb to 5% in 2011.
Exhibit 4
Fundamentals Still Point to Significantly Higher Real
Rates
10
10-year Treasury yield less year-over-year
percent change in core CPI (percent)
9
8
7
6
5
Long-run average
4
3
2
1
0
81
83
85
87
89
91
93
95
97
99
01
03
05
07
09
11
Note: April 2010-December 2011 values represent Morgan Stanley Research estimates.
Source: Federal Reserve Board, Bureau of Labor Statistics, Morgan Stanley Research
But a second, more ominous factor also lurks: namely
questions about US resolve to deal with the unsustainable path
for fiscal policy. As global investors seek the safety of US
Treasury debt, US sovereign credit risk is far from most
investors’ minds. Moreover, a recovery that promotes cyclical
shrinkage in deficits may extend comfort with those risks. In
contrast, we believe that the current turmoil in markets is
masking the risk that US rates will go significantly higher once
the intractable nature of our longer-term fiscal problems
resurfaces.
.
9
See David Greenlaw, “Budget and Financing Outlook – A Few Bright
Spots in a Dark Tunnel,” May 7, 2010.
5
MORGAN
STANLEY
RESEARCH
May 10, 2010
US Economics
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