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Morgan Stanley Says It Was Wrong About Treasury Yields, Scraps Call on Curve Flattening

(Bloomberg) -- Morgan Stanley has thrown in the towel on one of its high-profile predictions for 2018 -- a call that the U.S. Treasury yield curve from the two-year to the 30-year would flatten completely.

The forecast was based on expectations for gradual monetary policy tightening by the Federal Reserve and deterioration in the forward growth outlook. Morgan Stanley’s global head of interest-rate strategy Matthew Hornbach broadened it in June, adding a two- to 10-year flattener and a bet that the 10-year yield had peaked for the year at 3.12 percent in mid-May.

Investors should go long at the prevailing level of 2.90 percent with a view toward a mid-2019 level under 2.75 percent, he said at the time.

Morgan Stanley Says It Was Wrong About Treasury Yields, Scraps Call on Curve Flattening

Last week, the pain threshold -- or at least the end of Hornbach’s patience -- was reached, as the 10-year yield climbed to fresh year-to-date highs north of 3.20 percent. The two- to 30-year curve spread, which fell as low as 32.9 basis points in September, topped 50 basis points. On Friday, Hornbach canceled the long recommendation as well as the flatteners.

“We were wrong to expect Treasury yields to be capped at previous year-to-date highs,” Hornbach said in a note titled “Our mea culpa.” Morgan Stanley’s inclination to be long duration “ended the moment yields broke those levels.”

What changed? A second straight month of strong U.S. economic data “has caused investors to reevaluate the prospects for both Fed policy and future economic growth.” That trend could continue, Hornbach said.

Steepening could go further as well, whether yields rise or fall. But it’s too soon to bet on it because if the economic data keep surprising to the upside, investors will start expecting Fed policy makers “to become even more hawkish into year-end,” and the curve “will find it tough to trend steeper.”

The curve continued to steepen during London hours on Tuesday following the Columbus Day holiday. The 30-year yield rose 3 basis points to 3.44 percent -- the highest level since July 2014 -- as focus began to shift to this week’s long-dated bond auctions. The yield on the two-year note dropped 1 basis point while the 10-year yield rose 1 basis point to 3.25 percent.

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