Morgan Stanley Defends `Most Controversial' Treasury-Curve Call

(Bloomberg) -- When you have one of the most contentious projections on Wall Street for the U.S. Treasury market, it’s hard to avoid the limelight.

Morgan Stanley’s forecast that the difference between yields on short- and long-dated U.S. government bonds will narrow to zero late next year is spurring strong push back even as the gap tumbles to decade lows, the bank notes.

The forecasts -- on both the shape and level of the curve -- have the potential to roil bond trades and the Federal Reserve’s tightening path, while raising concern for a downturn in the business cycle.

Morgan Stanley Defends `Most Controversial' Treasury-Curve Call

To recap: Matthew Hornbach, chief rates strategist, reckons the 10-year note will tumble to 1.95 percent by the end of the year -- compared with the Bloomberg consensus of 2.83 percent -- while the 30-year obligation will hit 2 percent, a record low.

He also projects the gap between two- and 30-year Treasuries will tumble to 0.1 percent by the end of 2018, compared with the 1.10 percent median consensus according to a Bloomberg survey.

In a Sunday note, Andrew Sheets, chief cross-asset strategist at the bank, mounted a defense of its flat-curve projection, the bank’s “most controversial call, by a country mile.”

"Investors, it’s safe to say, disagree, seeing reasonable growth, rising inflation, Fed hikes and balance sheet reduction leading to higher long-end rates," he notes.

Key to their view: tighter financial conditions late in the business cycle will trigger traders to price in a weaker U.S. economic outlook from the second half of the year, capping yields at the long end of the curve -- while excess global savings will fuel demand for duration.

An uptick in U.S. inflation and a rise in long-dated yields triggered by Fed’s balance-sheet plan or the Republican tax plan are all potential triggers for a steeper curve.

Not so fast, say Sheets and Hornbach.

The Fed will be raising rates close to the terminal rate -- the level that keeps supply and demand in the U.S. economy balanced over the long haul -- while the flat curve has been consistent with stable real growth and inflation in the past. Both suggest the stars are aligning for the gap across Treasury maturities to effectively vanish -- at a record-low absolute level of rates.

“We expect the Treasury curve to flatten completely by 3Q18 driven by a Fed that hikes rates slightly more than the consensus expects with inflation still running below its 2 percent target," Hornbach wrote in a report on Friday. "Real policy rates will have risen very close to neutral policy."

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