Morgan Stanley says Fed rate bets too high, buy five-year notes

[NEW YORK] Morgan Stanley says investors are overestimating the chances of higher US interest rates this year and should buy five-year Treasury notes.

From coin-flip odds of a rate increase by December, the New York-based bank's strategists predict the probability will drop to 30 percent in coming weeks as inflationary pressures remain absent from the world's biggest economy. Benchmark Treasuries held gains on Thursday after minutes of the Federal Reserve's July meeting published the previous day showed officials saw little risk of a sharp uptick in consumer prices.

"Inflation holds the key to further Fed rate hikes," Matthew Hornbach and Guneet Dhingra wrote in a note to clients. "The market should take a September hike off the table and adjust lower the probability of a December hike accordingly."

Bond bulls have been emboldened as mixed domestic data, coupled with signs of slowing growth around the world, stayed the Fed's hand since it raised rates from near zero in December. Officials have twice cut their projections for the path of increases this year. A JPMorgan Chase & Co survey showed the largest net long positions for two months in the week ended Aug. 15.

The 10-year note yield was little changed at 1.56 per cent as of 9:55 am in London, after declining three basis points Wednesday, according to Bloomberg Bond Trader data. The price of the 1.5 per cent security due August 2026 was 99 15/32. The five-year yield was little changed at 1.14 per cent, while two-year securities yielded 0.73 per cent.

Five-year securities reached the cheapest level relative to two- and 10-year Treasuries in a month on Wednesday, according to the so-called butterfly spread.

Morgan Stanley expects two-year yields to drop toward 0.65 per cent as Fed rate-rise bets get pared back, while also predicting the yield curve will flatten, reducing the premium offered by the five-year note.

The Wall Street firm called this year's Treasury market rally, and last month revised down its forecast for the 10-year yield to 1 per cent in the first quarter of 2017. That's the most bullish among 61 estimates compiled by Bloomberg. The yield reached a record 1.318 per cent on July 6.

The probability of a US rate increase in 2016 is 49 per cent, according to Bloomberg calculations based on fed fund futures. The odds have risen from 36 per cent at the end of July.

New York Fed President William Dudley holds a news briefing Thursday, after saying this week that an interest-rate increase could come as soon as next month, and the bond market looks "a little bit stretched." Chair Janet Yellen speaks Aug 26 at an annual symposium hosted by the Kansas City Fed in Jackson Hole, Wyoming.

Limits on how far and how fast US policy makers can raise rates will send the 10-year Treasury yield to 1.30 per cent in three months, according to Daniel Lenz, a market strategist at DZ Bank AG in Frankfurt.

"The minutes were far from giving a clear picture on how the Fed thinks," Mr Lenz said. The Fed's focus seems to have shifted from the labour market to inflation and "it's obvious inflationary pressures are not very high," he said. Mr Lenz predicts the Fed will hold policy unchanged in September and may increase rates at the end of this year or early next year.

The Treasury is scheduled to auction US$14 billion of five- year inflation-protected notes later Thursday.

BLOOMBERG