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Morgan Stanley - High Enough

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High Enough?

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									                                                                           MORGAN STANLEY RESEARCH

                                                                           Morgan Stanley & Co. LLC     Matthew Hornbach
                                                                                                        Matthew.Hornbach@morganstanley.com
                                                                                                        +1 (212) 761-1837

                                                                                                        Vipul Jain, CFA

                                                                                                        Subadra Rajappa

                                                                                                        Michael Ortiz

          May 3, 2013                                                                                   Tiffany Wilding

                                                                                                        Guneet Dhingra, CFA
North     US Interest Rate Strategist                                                                   Ankur Shah
America
          High Enough?                                                                                  Mikhail Levin

          We suggest investors enter 7s/30s and 10s/30s yield                                           Emily Zheng
          curve steepeners. While the 7s/30s and 10s/30s
          curves have been trading more directionally since
          QE∞ was announced, these steepeners get you                      Regular Features
          slightly short duration and with positive carry and                   Our Views
          rolldown – the holy grail of bond market investing.
                                                                                In Case You Missed It
          US Governments                                                        Event Calendar
          We look at ways of enhancing rolldown by adding                       Government Bond Supply
          exposure to forward rates in Treasuries. We found that the            Treasury Yield Forecasts
          5y1y forward rate on the Treasury curve offers the best               Market Data Summary
          rolldown. We recommend selling $79.9mm 3.875 May18s                   Trade Ideas
          versus buying $100mm 3.125 May19s to gain exposure to
          the 5-year forward 1-year rate.                                  Global Strategists
          US Treasury Inflation Protected Securities                            Spring Global Strategy Outlook
          Investors are no longer willing to pay a premium for inflation        European Interest Rate Strategist
          protection – intermediate and long-dated forwards are now             Japan Interest Rate Strategist
          pricing to the Fed’s long-term goal. If the measures continue         The Inflation Strategist
          to fall, the Fed will likely respond. We still think they can         Agency MBS Weekly
          achieve shock and awe.                                                                      L ow er/F latter          Highe r/Ste ep er
                                                                                                         Tighter                    Wid er
          US Short Duration Strategy
                                                                                                             –                         +
          Overnight repo cheapened into month-end but should               US Treas ury Yields
          decline with the continued reduction in bill supply. We          US Treas ury C urve
          should get more clarity on several key regulatory                US TIPS Breakevens
          proposals over the coming months. New regulations could          US TIPS BEI C urve
          dramatically alter the money market landscape.                   USD Sw ap Spreads
                                                                           USD Sw ap Spread C urve
          US Interest Rate Derivatives: Swaps                              USD Sw aptio n Gam m a
          We analyze spreads in the context of Treasury refunding          USD Sw aptio n Ve ga
          news. Although repo rates tend to drive front-end spreads        US Age ncy MBS Basis
                                                                           US Age ncy MBS Up-In -C ou pon
          we do not foresee a large short term impact to front-end
                                                                           US Age ncy MBS GN /FN
          spreads from changes in issuance. We also take a look at         US Age ncy MBS 15/3 0
          issuance/spread correlation on the back-end.
                                                                                                                    Prior      C urren t
          US Interest Rate Derivatives: Volatility
          Gamma was bid after the April NFP report, but remains             Due to the nature of the fixed income market, the issuers or
          close to its historical lows. We are skeptical that gamma         bonds of the issuers recommended or discussed in this report
          will rally absent a sustained rate selloff. Our revised           may not be continuously followed. Accordingly, investors must
          framework around the Evans rule suggests gamma may                regard this report as providing stand-alone analysis and should
          stay low relative to term premiums. We recommend limited          not expect continuing analysis or additional reports relating to
          downside triangle trades for high rolldown and carry.             such issuers or bonds of the issuers.
                                                                            Morgan Stanley does and seeks to do business with
          US Agency Mortgage-Backed Securities
                                                                            companies covered in Morgan Stanley Research. As
          It was a volatile week in the mortgage market. FN2.5 was          a result, investors should be aware that the firm may
          the best performer on the coupon stack, while the belly           have a conflict of interest that could affect the
          coupons underperforming due to concerns around the                objectivity of Morgan Stanley Research. Investors
          extension of HARP after Rep. Mel Watt’s nomination as a           should consider Morgan Stanley Research as only a
          FHFA director. There is still uncertainty around Mel Watt’s       single factor in making their investment decision.
          appointment, and the HARP% reported by the MBA                    For analyst certification and other important
          surprised to the upside.                                          disclosures, refer to the Disclosure Section,
                                                                            located at the end of this report.
                                                                               MORGAN STANLEY RESEARCH

                                                                               May 3, 2013
                                                                               US Interest Rate Strategist




Our Views
                                        Our Views                                                                Suggested Strategies
US Treasuries
    We remain tactically neutral on duration. We suggest investors enter 7s/30s and
     10s/30s yield curve steepeners. While the 7s/30s and 10s/30s curves have been
     trading more directionally since QE∞ was announced, these steepeners get you
     slightly short duration and with positive carry and rolldown – the holy grail of bond
     market investing.
    Most Japanese life insurance companies have announced or hinted at their planned                 Neutral outright duration
     investment in non-yen bonds for fiscal year 2013. We estimate that lifers are planning
                                                                                                      Long 10s on 5s/10s/30s PCA Fly (DV01 weights:
     to invest approximately $13 to $20 billion abroad – below their trend pace of $24
                                                                                                       0.60/1.0/0.62)
     billion per year since 2009 – if 20-year JGB yields remain below 1.3%.
                                                                                                      Short 15s on 10s/15s/30s PCA Fly (DV01
    We focus on trades that (1) are not market directional and, (2) offer positive rolldown
                                                                                                       weights: 0.56/1.0/0.53
     and carry.
                                                                                                      7s/30s or 10s/30s curve steepeners
    We prefer 2s/10s curve flatteners for those who believe the curve will flatten further,
     and prefer 7s/30s or 10s/30s curve steepeners for those who believe the curve will
     steepen. We see these steepeners as a positive carry way of being short duration.
    As long as we remain in the fiscal cliff interest rate regime – a range we suggested
     was a 10-year Treasury yield of 1.4-2.6% – the best medium-term investment strategy
     for investors will be to focus on carry and expected rolldown.
US Treasury Inflation-Protected Securities
    Within a ‘credible Fed’ trading regime, the Fed’s longer-term PCE inflation target will
     result in a shift in the point on the curve where the market prices the largest inflation
     risk premium, while the 2.5% projected PCE inflation parameter will ultimately cap the
                                                                                                      Cautiously long breakeven level
     extent to which intermediate inflation risk premiums can rise. We see intermediate
                                                                                                      Overweight the 15- to 20-year sector of real yield
     forwards being capped at 2.8% to 3.0%.
                                                                                                       curve
    We forecast spot breakevens to move sideways to slightly lower in 2013, as a
                                                                                                      Long TIPS ASW vs. Nominal ASW
     moderation in headline CPI inflation puts pressure on spot breakeven spreads.
    The recent drop in 5y5y forward breakevens is symptomatic of a decline in inflation              Long 10-year Breakeven vs. 10s/30s UST Curve
     risk premium priced into the breakeven curve. Intermediate and long-dated forwards
     are now pricing to the Fed long-term inflation objective.
US Interest Rate Derivatives: Swaps
    We continue to fundamentally like wideners, although given the recent moves wider,
     we recommend waiting for a better entry level.
    Recent price action has been driven by a combination of factors. Relatively stable               Short 20s on 10s/20s/30s swaps fly weighted
     interest rates and equity market strength has strengthened pension and ALM balance                50/50
     sheets, reducing their need to receive long-dated swaps. Increasing trading costs due            Long 7s on 3s/7s/10s swaps fly weighted 50/50
     to Dodd-Frank regulation have spurred positioning, while technical flows due to PRDC
     hedging have contributed to wider spreads.
US Interest Rate Derivatives: Vol
    We have turned neutral from bullish on gamma, as newer FOMC guidance has
     caused us to revise how we believe economic volatility affects rate volatility. The              2y 1s/5s bull flatteners
     Evans rule has likely depressed volatility by lowering the impact of FOMC statements.            Notional-neutral 1y 10y/30s bull steepeners
    Volatility has been closely linked to term premiums. We believe using term premium               Buy 30y gamma against 10y gamma
     as a metric for fair value is a more accurate and stable indicator than outright rates.          6m 1s/2s OTM bear steepeners
    We like long-term rolldown and carry trades. We also believe 30-year gamma is                    6m5y5y triangles
     cheap to 10-year gamma, as QE∞ uncertainty may spur moves in the 10s/30s curve.
US Agency Mortgage-Backed Securities
    We recommend a small long in the mortgage basis as QE-related technicals are
     intact. Carry on production coupons is attractive because of better rolls. Given the
     underperformance in the last two trading sessions since the FOMC statement,                      Overweight the mortgage basis (FN3/3.5s)
     mortgage basis is at a local wide.                                                               Overweight the GD/FN 3 swaps
    We recommend down-in-coupon in conventional 30s. We like GD/FN 3 swaps at the
     current level.




                                                                                                                                                     2
                                                                                MORGAN STANLEY RESEARCH

                                                                                May 3, 2013
                                                                                US Interest Rate Strategist




In Case You Missed It
                                       Key Themes                                                                     Detailed Coverage
Comfortably Numb                                                                                 April 26, 2013
                                                                                                      Free Falling
    We remain tactically neutral on duration and curve shape. While economic data                    Short 15s on the 10s/15s/30s PCA Butterfly
     seem poised to continue underperforming consensus expectations, we are at the                    Carving up the Curves
     lower bound of our expected range for yields this quarter with market sentiment very             Supply Matters
     balanced. With the FOMC meeting and the nonfarm payroll report coming up, our                    Trading the Expiry Curve
     appetite for risk is low.
                                                                                                      Around the Range in 80 Days
                                                                                                      Download Report
Trouble with the Curve                                                                           April 19, 2013
                                                                                                      What Would Winston Do?
                                                                                                      What If Tapering is Delayed?
                                                                                                      Shifting to Neutral
    Our analysis on the effects of tapering or lack thereof on the yield curve suggest that          Breakevens – A Perfect Storm
     risks are skewed to a flatter 10s/30s curve if market expectations of tapering move
                                                                                                      Banking on Domestic Deposits
     closer to the Morgan Stanley forecast. We turn neutral on curve shape and stay
     neutral on duration.                                                                             Spread Curve RV
                                                                                                      QE∞ Tapering Driving 10s/30s Vol
                                                                                                      Scaling Down the Basis Overweight
                                                                                                      Download Report
Soft Patch Risks                                                                                 April 12, 2013

    We remain neutral on duration and TIPS breakevens tactically, and prefer long end                Accounting for Curve Risks
     curve steepeners strategically. We are neutral on swap spreads tactically, and on                Trading Around Wider Spreads
     implied volatility strategically. The largest risk to our strategic views is an economic         Hedging the Steepener
     soft patch that goes beyond our expectations and significantly beyond market                     Support Stays Strong
     expectations – calling into question second half growth prospects.
                                                                                                      Download Report
Jitters from Japan                                                                               April 5, 2013
                                                                                                      Emotion in Motion
                                                                                                      10s/30s Steepener – The Forces Unite
    We maintain our curve steepening view following the BoJ’s aggressive change in                   Curious Case of Clearing Volumes
     policy. While we see scope for demand to increase from Japan, we believe this                    Tracking the Flows
     demand would concentrate in GNMA mortgages and high rolldown and carry sectors                   Analyzing Swap Spread Drivers
     of the Treasury curve – keeping the back end of the yield curve steep.                           The Right Time to Roll
                                                                                                      Back to Levered Carry Trade?
                                                                                                      Download Report
Return of the Fedi                                                                               March 22, 2013
                                                                                                      A Tale of Two Steepeners
    The FOMC laid the groundwork for another set of exit strategy principles – some of               The Real Story Behind an Old Equity Adage
     which hinge on the distinction between "sustained" and "substantial" improvement in
                                                                                                      Hedging Cyprus with a Spread Curve Flattener
     the labor market. Despite the threat of tapering to bond purchases, we maintain our
     view that QE∞ will continue at its current pace through 2013. May the Force be with              Vol: Two Trades for Two Stories
     you.                                                                                             MBS: Tapering Fears
                                                                                                      Download Report
2.00% Strikes Back                                                                               March 15, 2013
                                                                                                      To Roll or Not to Roll?
                                                                                                      Real Curve Hat-TIPS the Fed
    10-year Treasury yields returned to the Dark Side of 2.00%. The Force of carry and               Regulatory Hurdles
     rolldown remains strong. While investors may find the lack of movement this week
                                                                                                      Relative Value Around Front-End Steepeners
     disturbing, the upcoming FOMC meeting, updated projections, and press conference
     may help us find the droids we're looking for.                                                   Hedging Faster Hikes
                                                                                                      Fears Come True?
                                                                                                      Download Report


                                                                                                                                                      3
                                                                                                     MORGAN STANLEY RESEARCH

                                                                                                     May 3, 2013
                                                                                                     US Interest Rate Strategist




Event Calendar
              Monday                                 Tuesday                              Wednesday                                Thursday                                    Friday

               6-May                                   7-May                                  8-May                                  9-May                                     10-May

EUR: ECB’s Draghi speaks               US: Consumer Credit                     US: Fed’s Stein speaks                 US: Jobless Claims                     US: Fed’s Bernanke, Evans,
                                                                                                                      US: Wholesale Trade                    George speak
                                                                                                                      US: Fed’s Lacker, Plosser              INT: G8 Meeting
                                                                                                                      speak
                                                                                                                      CNY: CPI
                                                                                                                      UK: BoE Rate Decision
                                                                                                                      UK: GDP



               13-May                                 14-May                                 15-May                                  16-May                                    17-May

US: Retail Sales                       US: Import/Export Prices                US: PPI                                US: Jobless Claims                     US: U. Michigan Consumer
EUR: Eurogroup meeting                 US: Fed’s Plosser speaks                US: Empire State Survey                US: CPI                                Sentiment
                                       EUR: EcoFin meeting                     US: Industrial Production              US: Housing Starts                     US: Fed’s Kocherlakota
                                                                                                                                                             speaks
                                                                               EUR: GDP                               US: Fed’s Williams speaks
                                                                                                                      JPY: GDP

Source: Morgan Stanley Research, Bloomberg




Government Bond Supply
               06-May                                  07-May                                 08-May                                  09-May                                     10-May

US: 3m T-Bill $29bn, 6m T-Bill         US: 1m T-Bill $30bn*                      US: New 10-Year UST, $24bn          US: 3m, 6m T-Bill Announcement    NOR: NGB Auction, NOK3bn*
$24bn                                  US: New 3-Year UST, $32bn                 GER: New OBL April 2018,            US: New 30-Year UST, $16bn
US: 1m T-Bill Announcement             GER: DBRi 0.1% April 2023 Tap,            €5bn                                SPA: Bono Auction Tap, €4bn*
NOR: NGB Announcement                  €1bn                                      ITA: BTP Announcement               SPGB 3.3% July 2016, SPGB 4.5%
                                       AUT: RAGB Auction, €1.32bn                UK: UKTi 0.125% 2044 Tap,           January 2018, SPGB 5.9% July 2026
                                       RAGB 1.75 October 2023 and                £1.1bn                              CAN: 3y Nominal Auction
                                       RAGB 1.95% June 2019                      SWE: SGB Announcement               Announcement
                                                                                 NOR: NGB Announcement
                                                                                 CAN: 5y Nominal Auction,
                                                                                 CAD 3.4bn
                                                                                 JPY: Auction for Enhanced
                                                                                 Liquidity, ¥300bn

US OMO: 7-10y T ,$2.75 - $3.50b US OMO: 23-30y T ,$1.25 - $1.75bn US OMO: 6-7y T ,$3.00 -                            US OMO: 4-30y TII ,$1.00 - $1.50bn US OMO: 23-30y T ,$1.25 -
                                                                  $3.75bn                                                                               $1.75bn
               13-May                                  14-May                                 15-May                                  16-May                                     17-May

US: 3m T-Bill $29bn*, 6m T-Bill        US: 1m T-Bill $30bn*                      GER: New BKO June 2015,             US: 3m, 6m T-Bill Announcement       BEL: Optional Reverse Inquiry
$24bn*                                 NETH: DSL 1.25% January 2018              €5bn                                US: 10y TIPS Announcement            Option, €0-0.5bn*
US: 1m T-Bill Announcement             Tap, €1.5-2.5bn                           CAN: 3y Nominal Auction,            FRA: OAT Auction (2-5y), €7bn*
ITA: BTP Auction, €6bn*                UK: UKT 1.25% July 2018 Tap,              CAD 2.7bn*                          (Possible OAT 1% May 2018 Tap,
                                       £3.5bn*                                   SWE: SGB Auction, SEK               €3.5bn*, BTNS 0.75% September
                                       NOR: NGB Auction, NOK3bn*                 3.5bn                               2014 Tap, €2.5bn* and an off-the-run
                                       DEN: DGB Auction, DKK 3bn*                                                    Tap, €1bn*)
                                       JPY: 30y JGB, ¥600bn*                                                         FRA: Linker Auction, €2bn*
                                                                                                                     UK: UKT 3.25% January 2044 Tap,
                                                                                                                     £1.25bn*
                                                                                                                     SWE: SGBi Announcement
                                                                                                                     CAN: 30y Nominal Auction
                                                                                                                     Announcement
                                                                                                                     JPY: 5y JGB, ¥2700bn*

                                       US OMO: 7-10y T ,$2.75 - $3.50bn US OMO: 10-18y T ,$0.75 -                    US OMO: 23-30y T ,$1.25 - $1.75bn US OMO: 5-6y T ,$4.75 -
                                                                        $1.00bn                                                                        $5.75bn
Source: National Treasuries, Federal Reserve, Morgan Stanley Research
Note: * = Size Estimated; ** = Maturity Unknown, *** Syndication/Mini Tender will happen in the week commencing. T: Treasury Purchase, TII: TIPS Purchase, S: Treasury Sales




                                                                                                                                                                                          4
                                                                                          MORGAN STANLEY RESEARCH

                                                                                          May 3, 2013
                                                                                          US Interest Rate Strategist




Treasury Yield Forecasts
                                       Base Case                                                                2Q13 Forecast vs. Forwards
Quarter      Hike Exp          2y            3y        5y      7y     10y    30y                              Current         Forecast     Market Fwd       Forecast
1Q13            -            0.28       0.42         0.84    1.32    1.95   3.11                              Market           2Q13          2Q13           less Fwd
2Q13           +3m           0.31       0.46         0.90    1.39    2.03   3.19               Maturity         (%)             (%)           (%)              (bp)
3Q13           +3m           0.33       0.50         0.95    1.44    2.08   3.25               Yield
4Q13           +1m           0.44       0.62         1.09    1.60    2.29   3.46               2-Year                0.222         0.308            0.252            5.6
1Q14            -            0.58       0.80         1.29    1.81    2.46   3.63               3-Year                0.350         0.465            0.392            7.2
                                                                                               5-Year                0.723         0.904            0.777           12.7
                                                                                               7-Year                1.171         1.390            1.232           15.8
                                       Bull Case
                                                                                               10-Year               1.798         2.032            1.853           17.9
Quarter      Hike Exp          2y            3y        5y      7y     10y    30y               30-Year               2.976         3.195            2.998           19.7
1Q13           +4m           0.15       0.25         0.62    1.08    1.71   2.86               Curve
2Q13           +9m           0.15       0.25         0.40    0.78    1.40   2.55               2s/3s                 0.128         0.156            0.140            1.6
3Q13           +3m           0.15       0.25         0.40    0.76    1.38   2.53               2s/5s                 0.502         0.595            0.525            7.0
4Q13           +3m           0.15       0.25         0.40    0.77    1.43   2.57               2s/7s                 0.950         1.082            0.980           10.2
1Q14           +3m           0.15       0.25         0.40    0.76    1.37   2.51               2s/10s                1.576         1.723            1.601           12.2
                                                                                               2s/30s                2.754         2.886            2.746           14.1
                                                                                               3s/5s                 0.373         0.439            0.385            5.4
                                       Bear Case
                                                                                               3s/7s                 0.822         0.926            0.840            8.6
Quarter      Hike Exp          2y            3y        5y      7y     10y    30y               3s/10s                1.448         1.567            1.460           10.7
1Q13          -1.5m          0.34       0.50         0.93    1.40    2.04   3.19               5s/7s                 0.448         0.487            0.455            3.2
2Q13             -           0.50       0.69         1.16    1.65    2.29   3.45               5s/10s                1.075         1.128            1.076            5.2
3Q13             -           0.66       0.88         1.38    1.88    2.53   3.69               5s/30s                2.252         2.291            2.221            7.1
4Q13             -           0.81       1.07         1.59    2.10    2.79   3.94               7s/10s                0.627         0.641            0.621            2.1
1Q14             -           0.97       1.24         1.78    2.30    2.94   4.09               7s/30s                1.804         1.805            1.766            3.9
                                                                                               10s/30s               1.177         1.163            1.145            1.8
                                                                                               Butterfly
                              Base Case Risk Channel
                                                                                               2s/3s/5s              -0.245       -0.283        -0.244              -3.9
Quarter      Hike Exp          2y            3y        5y      7y     10y    30y               2s/5s/7s               0.054        0.108         0.070               3.9
Current         -            0.15       0.25         0.60    1.07    1.70   2.86               2s/5s/10s             -0.573       -0.533        -0.551               1.8
Current         -            0.35       0.51         0.95    1.43    2.07   3.22               2s/5s/30s             -1.750       -1.696        -1.696               0.0
1Q13            -            0.15       0.25         0.59    1.05    1.68   2.83               2s/7s/10s              0.323        0.440         0.359               8.1
1Q13            -            0.34       0.50         0.93    1.40    2.04   3.19               2s/7s/30s             -0.854       -0.723        -0.786               6.3
2Q13           +3m           0.15       0.25         0.63    1.11    1.74   2.90               2s/10s/30s             0.399        0.560         0.456              10.4
2Q13           +3m           0.37       0.54         0.99    1.48    2.12   3.28               3s/5s/7s              -0.075       -0.048        -0.071               2.3
3Q13           +3m           0.23       0.37         0.79    1.28    1.92   3.09               3s/5s/10s             -0.701       -0.689        -0.691               0.2
3Q13           +3m           0.40       0.57         1.04    1.53    2.18   3.35               3s/10s/30s             0.271        0.404         0.315               8.8
4Q13           +1m           0.37       0.54         1.00    1.50    2.19   3.36               5s/7s/10s             -0.179       -0.155        -0.165               1.1
4Q13           +1m           0.50       0.70         1.19    1.69    2.39   3.56               5s/7s/30s             -1.356       -1.318        -1.310              -0.7
                                                                                               5s/10s/30s            -0.103       -0.035        -0.069               3.4
                                                                                               7s/10s/30s            -0.551       -0.522        -0.524               0.2
      10-Year Base Case Forecast | Realized Yield | Risk Channel                                   10-Year Bull | Bear | Base Case Scenarios

  %                                                                                %
 2.60                                                                              4.40                                                                      Base
                        Forecast yield (%)
                        Risk Channel                                                                                                                         Bull
 2.40                                                                              3.90                                                                      Bear
                        Actual Yield

 2.20                                                                              3.40

 2.00                                                                              2.90

 1.80                                                                              2.40

 1.60                                                                              1.90

 1.40                                                                              1.40

 1.20                                                                              0.90
    Jan-12       Jul-12        Feb-13             Aug-13    Mar-14                    Jan-10     Sep-10     May-11     Jan-12    Oct-12    Jun-13     Feb-14
Source: Morgan Stanley Research
Updated on: 03, May 2013
For more information on our rate forecast methodology please consult US Interest Rate Strategist: Unconventional Uncertainty.


                                                                                                                                                                           5
                                                                          MORGAN STANLEY RESEARCH


                                                                          May 3, 2013
                                                                          US Interest Rate Strategist



US Interest Rates
Can You Take Me High Enough? Back in Curve Steepeners
Matthew Hornbach (212) 761-1837                                                         Enter UST 10s/30s curve steepener, DV01 neutral

                                                                                               o     Buy 100mm T 2.000 2/23
         We suggest investors enter 7s/30s and 10s/30s yield curve
          steepeners. While the 7s/30s and 10s/30s curves have been                            o     Sell 44.1mm T 3.125 2/43
          trading more directionally since QE∞ was announced, these
          steepeners get you slightly short duration and with positive    Exhibit 1
          carry and rolldown – the holy grail of bond market investing.   Actual Private Nonfarm Payrolls
         We discuss our views on the FOMC statement. We do not
                                                                          + Net 2-Month Revisions
          believe the Fed is likely to change or even “tweak” the pace          '000s
          of purchases until 2014.                                              350
         Last week, we suggested that the decision by lifers in Japan
                                                                                                                                        300k
          to allocate more investment abroad would be dependent on              300                                           285k
          the level of 20-year Japanese Government Bond (JGB)
          yields relative to 1.3%. We answer the “why” this week.               250                                  242k


Nonfarm Payrolls – I Want to Take You Higher                                    200
The nonfarm payroll report for April was the biggest number
since the January report (released in early February) when                      150
taking the net revisions for the prior two reports into account
(see Exhibit 1). The report placed upward pressure on yields                    100
in the immediate wake of the release and, on a longer
horizon, could reverse the bullish tone set by the                                  50
disappointing report last month. Keeping in mind the language                            Apr-12     Jul-12     Oct-12        Jan-13   Apr-13
Chairman Bernanke used in describing the Fed’s desire for
                                                                          Source: Morgan Stanley Research, BLS
sustained improvement in the labor market – both recent
trends and the outlook for those trends – the April nonfarm               Exhibit 2
payroll report will ease tensions that may have invaded the               Private Nonfarm Payrolls vs. Moving Averages
psyche of the April 30/May 1 FOMC meeting.
                                                                                '000s
On a trend basis, private nonfarm payrolls moved closer to                      350
sustained improvement on a 9-month and 12-month moving
average basis. Even though the 6-month moving average fell                      290
slightly (222k → 216k), the 9-month moving average was
unchanged (195k → 195k) and the 12-month moving average
                                                                                230
was up (176k → 181k) . Exhibit 2 shows the one-year history                                                                                  216k
of private nonfarm payroll growth and the moving averages.                                                                                   195k
Despite what the market took as good news relative to                           170                                                          181k

expectations, the rounding of the 6-month moving average
reminds us that the soft patch remains a factor in the outlook                  110
for the US economy. From that perspective, we want to
remain neutral on duration; but, given the possible reversal in
sentiment and possible bottoming in economic data relative to                       50
consensus (see Exhibit 3), we suggest investors:                                         Apr-12        Aug-12           Dec-12        Apr-13
                                                                                          Private Nonfarm Payrolls          6MMA      9MMA          12MMA
            Enter UST 7s/30s curve steepener, DV01 neutral
                                                                          Source: Morgan Stanley Research, BLS

                   o    Buy 100mm T 1.125 4/20

                   o    Sell 32.3mm T 3.125 2/43



                                                                                                                                                            6
                                                                             MORGAN STANLEY RESEARCH

                                                                             May 3, 2013
                                                                             US Interest Rate Strategist




Exhibit 3                                                                    Exhibit 5
Bloomberg US Economic Surprise Index                                         UST 10-Year Yield History | Forecasts | Risk Channel
   Z-score                                                                        %
    1.2                                                                         2.60                              Forecast Yield

    1.0                                                                                                           Risk Channel
                                                                                2.40
                                                                                                                  Actual Yield
    0.8
    0.6                                                                         2.20

    0.4                                                                         2.00
    0.2
    0.0                                                                         1.80

   -0.2                                                                         1.60
   -0.4
                                                                                1.40
   -0.6
   -0.8                                                                         1.20
     Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14                              Dec-11         Jul-12       Jan-13    Aug-13    Mar-14

Source: Morgan Stanley Research, Bloomberg                                   Source: Morgan Stanley Research



We suggest avoiding curve steepeners between the front end                   Exhibit 4 shows the difference in directionality between the
and the 7- to 10-year point because (1) they proxy duration                  2s/7s and 7s/30s Treasury yield curves. While being at the
and we are neutral on duration, and (2) they carry and roll                  lower bound of our risk channel (see Exhibit 5) might suggest
negatively. While the 7s/30s and 10s/30s curves have been                    getting short duration, the width of our risk channel suggests
trading more directionally since QE∞ was announced, these                    that rates could remain low for the next month, and we do not
steepeners get you slightly short duration and with positive                 want to pay carry and rolldown to wait. The risk to both
carry and rolldown – the holy grail of bond market investing.                steepeners is a flattening driven by growth concerns.

Exhibit 4                                                                    Thoughts on the FOMC
CMT 2s/7s and CMT 7s/30s Yield Curves                                        The FOMC statement released this past week surprised both
vs. CMT 7-Year Yields Since QE∞                                              for what it said and what it did not say. The risk to the
                                                                             statement was language showing more concern over the
  Yield Curves (%)                                    y = 0.20x + 1.5358
                                                          R2 = 0.2865
                                                                             outlook for inflation and inflation expectations, but the text
 2.0                                                                         devoted to inflation was unchanged:
 1.8                                                                               Inflation has been running somewhat below the
 1.6                                                                               Committee's longer-run objective, apart from temporary
                                                                                   variations that largely reflect fluctuations in energy prices.
 1.4                                                                               Longer-term inflation expectations have remained stable.
 1.2                                                                         In fact, not much changed in the statement with one notable
 1.0                                                                         exception – the language devoted to the outlook for agency
                                                      y = 0.93x - 0.1794
                                                                             MBS and Treasury purchases:
 0.8
                                                         R2 = 0.9663               The Committee is prepared to increase or reduce the
 0.6                                                                               pace of its purchases to maintain appropriate policy
 0.4                                                                               accommodation as the outlook for the labor market or
                                                                                   inflation changes.
    0.90         1.00        1.10   1.20     1.30           1.40      1.50
                             CMT 7-Year Yield (%)                            This language surprised us for two reasons. First, it suggested
            CMT 2s/7s Curve                        CMT 7s/30s Curve          the Fed was willing to further increase the pace of their
                                                                             purchases from $40bn agency MBS and $45bn US
Source: Morgan Stanley Research, Federal Reserve
                                                                             Treasuries. Based on Chairman Bernanke’s March 19-20


                                                                                                                                                7
                                                                      MORGAN STANLEY RESEARCH

                                                                      May 3, 2013
                                                                      US Interest Rate Strategist




FOMC meeting Q&A responses, we thought he signaled the                Why 1.3%?
Fed’s willingness to increase the pace of purchases, but only         In Japan, guarantee rates were much higher than actual
from a lower level than the current pace. Clearly, those at the       market interest rates for many years – causing strife within the
Fed concerned over financial stability remain a minority              industry (see Exhibit 6). The lifers probably kept their
unable to keep this language from the statement.                      assumed rates much higher than the market rate (closer to
Second, given the relative stability of forward inflation             their guarantee rates) during this time in order to avoid having
expectations, we did not expect the Fed to open their jacket to       to hold more reserves against those high guarantee rate
show the weapon they use to prevent inflation expectations            policies, amongst other reasons.
from falling out of control – additional asset purchases. The
market should consider this a just warning. Despite the Fed’s         Exhibit 6
admission that the pace of purchases could adjust upward, we          Japanese Top 8 Life Insurance Company Guarantee
do not believe the Fed is likely to change or even “tweak” the        Rates, Investment Yields and 20-Year JGB Yields
pace of purchases until 2014.                                                                     Weighted      Investment     Investment
                                                                                                   Average      Yield w/out Yield w/ Cap
                                                                                                 Guarantee       Cap Gains         Gains JGB 20-Year
Digging Deeper in Japan                                               Fiscal Year End              Rate (%)              (%)          (%)   Yield (%)
In our last weekly publication, we suggested that the decision
                                                                      March 2008                        3.04            2.87        2.27        2.08
by life insurance companies in Japan to allocate more or less         March 2009                        2.90            2.61        0.55        1.95
investment abroad would be dependent in part on the level of          March 2010                        2.80            2.52        2.12        2.17
20-year Japanese Government Bond (JGB) yields relative to             March 2011                        2.68            2.55        2.04        2.05
                                                                      March 2012                        2.59            2.49        2.02        1.75
1.3%. We received two questions on this point from several            Source: Morgan Stanley Research, Company disclosures
readers:
                                                                      On April 1, 1999 – the beginning of the Japanese fiscal year –
Why the 20-Year Maturity?                                             lifers were made to lower their assumed rates to 2% for new
The 20-year maturity point is closest to the average duration         business. This gave them – or forced on them – a fresh start
of the liabilities of lifers in Japan, and so is the key point from   for new policies and allowed them to better institute ALM with
an asset-liability management (ALM) perspective. In addition,         a greater focus on JGBs instead of equities (Nikkei 225). As
30-year JGBs (JX series) were not issued until September              you can see from Exhibit 7, 20-year JGB yields fell
1999 (type JGB 2.8 9/20/29 Govt <GO> in Bloomberg) – after            precipitously into the April 1, 1999 effective date and even
lifers were forced to adjust lower their assumed rates to 2%          afterward. Remember, in April 1999, 30-year JGBs had not
(more on this later). So for years the lifers were doing ALM          yet been issued.
with 20-year JGBs primarily.
                                                                      Exhibit 7
The term most often used in the US (and in Europe) regarding          JGB 20-Year Yield Circa 1999
pension/life insurance hedging of liabilities is LDI (Liability           %
Driven Investment). Some people categorize LDI as a type of
                                                                         4.0
ALM, and some people consider them to be two related, but
slightly different strategies. In Japan, the strategy is referred
                                                                         3.5
to as ALM.
                                                                                                                   April 1, 1999
                                                                         3.0
In Japan, the life insurance policies agree to pay a rate of
return on the policies they issue – called the "guarantee rate".
                                                                         2.5
In order to figure out what rate to guarantee, what premiums
to charge, and how much to set aside for policy reserves,
                                                                         2.0
these companies come up with, or assume, a market interest
rate that will exist over the longer run. This interest rate is
                                                                         1.5
referred to as the "assumed rate", "actuarial rate" and/or
"technical rate". This is where ALM is said to differ from LDI –
                                                                         1.0
LDI uses actual market interest rates and ALM assumes a
                                                                           Apr 98           Oct 98             Apr 99          Oct 99       Apr 00
market interest rate – though the assumed rate can change.
                                                                      Source: Morgan Stanley Research



                                                                                                                                                        8
                                                                        MORGAN STANLEY RESEARCH


                                                                        May 3, 2013
                                                                        US Interest Rate Strategist



US Governments
Targeting Optimal Rolldown in Treasuries
Guneet Dhingra (212) 761-1445

                                                                         Exhibit 2 shows the total carry and rolldown across various
      One consequence of the recent flattening of the yield curve is
       the lowering of rolldown for Treasury investors, reducing
                                                                         spot and forward tenors on the Treasury curve, as calculated
       expected total returns from rolldown and carry.                   off the Treasury spline. Note that the spot rates include a
                                                                         carry component, while forward rates comprise of rolldown
      We look at ways of enhancing rolldown by adding exposure
                                                                         only. We can see below that the 5y1y and 5y2y rates offer
       to forward rates in Treasuries. We found that the 5y1y
                                                                         the best rolldown and carry – to the tune of 15bp. This is
       forward rate on the Treasury curve offers the best rolldown.
                                                                         approximately 6bp higher than the highest rolldown and carry
      We recommend selling $79.9mm 3.875 May18s versus                  investors can expect from owning the 7-year sector outright.
       buying $100mm 3.125 May19s to gain exposure to the 5-
       year forward 1-year rate.                                         Exhibit 1
      We also suggest a notional neutral version as well as a           3-Month Rolldown in the 5-, 7- and 10-Year Notes
       Treasury futures version of our trade, both of which offer
                                                                           bp                                                Declining
                                                                                                                                                   bp
       similar but less precise exposure to the 5-year forwards.
                                                                          7.0                                                rolldow n              5.5
      For the upcoming 3s, 10s and 30s auctions:

      - 3-Year Auction: 3s/5s Curve Flattener (2.0 / 1.0); Enter:
        May 3 close, Exit: May 7 close                                    6.0
      - 10-Year Auction: 7s/10s Spread Curve Steepener;                                                                                             5.0
        Enter: May 7 close, Exit: May 9 close

      - 30-Year Auction: Long 10s on 7s/10s/30s PCA                       5.0
        Weighted Fly (0.69/1.0/0.36); Enter: May 6 close, Exit: May
        16 close                                                                                                                                    4.5
                                                                          4.0

Searching For Optimal Rolldown
As the soft patch in the US economic data has played out in
                                                                          3.0                                                                     4.0
2Q13 (excluding today’s payroll report), the yield curve has
                                                                            Nov 12                                                            May 13
flattened significantly. One consequence of the flattening of
the yield curve is the lowering of rolldown for Treasury                             5Y Rolldow n            7Y Rolldow n            10Y Rolldow n (rhs)
investors, reducing expected total returns from rolldown and
                                                                         Source: Morgan Stanley Research
carry. Exhibit 1 shows the recent drop in 3-month rolldown
in the 5-, 7- and 10-year sectors.
                                                                         Exhibit 2
In this piece, we look at ways of enhancing rolldown by                  3-Month Rolldown and Carry Across Treasury
adding exposure to forward rates in Treasuries. We found                 Forward Rates
that the 5y1y forward rate on the Treasury curve offers the                                                           For (years)
best rolldown (see Exhibit 2). Investors can gain exposure to            In (years)            1         2           3        4        5      7       10
the forward rate by buying a bond in the 7-year sector versus            Spot                3.0       2.8         4.5      6.3      7.3    9.2      8.8
                                                                         1                   3.4       5.4         7.4      8.1      9.4    9.9      8.5
selling a bond in the 5-year sector. We recommend:
                                                                         2                   7.4       9.4         9.7     10.9     11.4   10.6      8.7
                                                                         3                  11.6      11.0        12.3     12.5     12.0   10.5      8.5
   Buy a Lower Coupon 6-Year Bond versus Higher                         4                  10.4      12.6        12.8     12.1     11.3    9.4      7.5
    Coupon 5-Year Bond                                                   5                  15.0      14.1        12.8     11.6     10.4    8.5      6.3
                                                                         * Rolldown numbers based of UST spline
   Sell $79.9mm 3.875 May18s                                            Source: Morgan Stanley Research


   Buy $100mm 3.125 May19s




                                                                                                                                                        9
                                                                                 MORGAN STANLEY RESEARCH


                                                                                 May 3, 2013
                                                                                 US Interest Rate Strategist


We target the 3.875 May18s and 3.125 May19s as these                              case) it is important to choose a lower coupon bond at the
bonds have nearly exactly five and six years to maturity.                         higher maturity point (six years in our case).
Additionally, it is important to target a lower coupon bond to
go long (as we explain later in this section). Lastly, while both                 Using a general collateral rate of 13bp for both the bonds in
bonds look rich versus our Treasury spline, the 3.125                             our calculations, we arrive at a hedge ratio of 0.799. We
May19s has cheapened significantly versus the 3.875                               acknowledge that this hedge ratio does not perfectly hedge
May18s over the past few months and is near its cheapest                          all the expected future cashflows on both the bonds, as repo
relative level in recent history (see Exhibit 3).                                 rates can change. However, we expect the repo rates to be
                                                                                  stable in the short term and do not expect moves in repo
Exhibit 3                                                                         rates to be a significant driver of the trade. The structure is
Rich Cheap Spread Between 3.125 May19s Versus                                     then primarily exposed to the cashflows after first bond
3.875 May18s                                                                      matures – a proxy for the 5-year forward 1-year rate.
  bp
                                                                                  Exposure to Forwards via Notional Neutral Switch
  0.0
                                                                                  A simpler version of our original trade would be to simply do
 -0.5                                                                             it in a notional neutral manner. However, in this case, it is
 -1.0                                                                             important to use a higher or equal coupon bond in the 7-year
 -1.5                                                                             sector versus the 5-year sector to ensure that the net
                                                                                  cashflow is positive at the end of five years. The cleanest
 -2.0
                                                                                  exposure would be by using equal coupon bonds. One
 -2.5                                                 3.125 May19s                possible way to structure such a trade is:
 -3.0                                                 cheaper vs
                                                      3.875 May18s                   Sell $100mm 2.625 Apr18s
 -3.5
 -4.0                                                                                Buy $100mm 2.625 Nov20s

 -4.5                                                                             While simpler, this structure has mismatching cashflow dates
    Nov 12                                                       May 13           and does not exactly target the 5-year forward 1-year sector.

                      3.125 May19s R/C - 3.875 May18s R/C
                                                                                  Exposure to Forwards via Treasury Futures
Source: Morgan Stanley Research                                                   Investors who invest primarily via futures can get exposure
                                                                                  similar to a 5-year forward 2-year rate via FV and TY futures
Replicating the Forward Rate Structure                                            contracts. We recommend:
To exactly replicate the 5-year forward 1-year rate, we need
                                                                                     Buy 1000 TY contracts
to cancel out the exposure to cashflows for the first five
years. The net recurring cashflow from owning a Treasury                             Sell 1000 FV Contracts
bond is the coupon payment on the notional amount minus
                                                                                  The cheapest to deliver (CTD) bonds for the FV and TY
the expected repo rate paid on the dirty price of the bond. To
                                                                                  contracts are 0.625 Nov17s (4.6 years to maturity) and 3.5
achieve a perfect hedge, the ratio of the notional amounts of
                                                                                  May20s (7 years to maturity) offering an exposure to the 4.6
the lower coupon bond to the higher coupon bond (or the
                                                                                  years forward 2.4 year rate. We choose the same notional on
hedge ratio) should be:
                                                                                  both contracts so that investors are exposed to a net positive
                                                                                  cashflow after the maturity of the FV CTD bond.
                   ( 100 * High Coupon - R1 * Dirty Pr ice HighCoup )
Hedge Ratio =
                    ( 100 * Low Coupon - R 2 * Dirty Pr ice LowCoup )             We note that this structure has residual exposures unlike our
where R1 , R2 are the repo rates on the high and low coupon bonds respectively    recommended trade in Treasuries. First, there are residual
                                                                                  coupon cashflows in the first five years. Second, it does not
                                                                                  have exactly matched cashflow dates on the underlying
If we assume equal repo rates on both the bonds, the
                                                                                  CTDs. And lastly, there is an additional basis risk between
calculations above suggest that the higher coupon bond will
                                                                                  the futures and the CTD bonds. Given current low yields,
need a lower notional amount than the lower coupon bond to
                                                                                  there is negligible probability of switching of the cheapest to
cancel out the coupon payments. Thus to have net positive
                                                                                  deliver (CTDs) bonds in these futures contracts.
cashflows at the end of the forward horizon (five years in our




                                                                                                                                               10
                                                                            MORGAN STANLEY RESEARCH


                                                                            May 3, 2013
                                                                            US Interest Rate Strategist


This risk to these trades is that the 5-year forward rates sell-             Reiterating Optimal Auction Trades
off by more than the rolldown cushion. The futures version
                                                                             Last week, we suggested optimal entry and exit timing for
and notional neutral versions of the trade have additional
                                                                             our preferred trades 2 for the upcoming 3-, 10- and 30-year
residual exposures from mismatched cashflows.
                                                                             Treasury auctions next week. We recommend:
Treasury Market Supply Update                                                3-Year Auction: 3s/5s Curve Flattener (2.0 / 1.0); Enter: May
The Treasury released the minutes of its Treasury Borrowing                  3 close, Exit: May 7 close
Advisor Committee earlier this week, with updates on the                     The trade has profited 9 times in the last twelve auctions;
following key issues:                                                        Average move in profit: 1.7bp; Sharpe ratio – 0.7

Coupon Sizes: The US Treasury announced that it expects                      10-Year Auction: 7s/10s Spread Curve Steepener; Enter:
to see stable coupon issuance in the second quarter in 2013.                 May 7 close, Exit: May 9 close
Additionally, the treasury statement suggests that it may
                                                                             The trade has profited 11 times in the last twelve auctions;
decide to decrease the current coupon sizes starting in 3Q13
                                                                             Average move in profit: 0.8bp; Sharpe ratio – 0.5
depending on how the outlook for the fiscal deficit in 2013
develops.
                                                                             30-Year Auction: Long 10s on 7s/10s/30s PCA Weighted
                                                                             Fly (0.69/1.0/0.36); Enter: May 6 close, Exit: May 16 close
Floating Rate Notes: Additionally, the Treasury decided to
use the weekly High Rate of 13-week Treasury Bill auctions                   The trade has profited 11 times in the last twelve auctions;
as the index for its proposed Floating Rate Note (FRN)                       Average move in profit: 1.1bp; Sharpe ratio – 0.9
issuance expected to begin either in 4Q13 or 1Q14. The
FRN issuance is expected to begin with two year maturity                     Positioning Imbalance Tracker
issues, with starting sizes of $10-$15bn per issue. The                      We highlighted the positioning imbalance monitor in our
Treasury will provide additional information regarding the                   publication 3 , March 8, 2013. We define the positioning
timing of the first auction at the August refunding. The                     imbalance on a given day as the percentage of open interest
Treasury will provide a final rule on FRNs in the coming                     added in the contract in the past sixty days that is currently
months.                                                                      offside. Exhibit 4 shows the total open interest caught
                                                                             offside and onside in 10-year equivalents across the five
Average Maturity of Treasury Debt: The Treasury also re-                     Treasury futures contracts as determined by the closing price
stated its policy of extending the average maturity of its debt.             on May 2. The FV and UL contracts have nearly 25% of
According to the TBAC Report to the Secretary of the                         open interest added in the past sixty days that is currently
Treasury 1 :                                                                 offside, and this is entirely driven by the new shorts that were
     As Fed policy tightens in the years to come, yields could               added in the past sixty days. Exhibit 5 shows the price point
     overshoot to the high side due to concerns of Fed portfolio             ranges at which open interest was established in the FV
     unwind and fixed income investor redemptions. Should this               contract over the past sixty days.
     occur, the higher cost of financing is material as annual
     interest expense could more than quadruple when yields
     “normalize.” Therefore, continuing to extend the weighted
     average maturity of Treasury debt in a stable manner so
     as to minimize term premium is sensible policy.




                                                                             2
                                                                                 US Interest Rate Strategist: Comfortably Numb
1                                                                            3
    http://www.treasury.gov/press-center/press-releases/Pages/jl1922.aspx        US Interest Rate Strategist: A New Hope


                                                                                                                                            11
                                                                           MORGAN STANLEY RESEARCH


                                                                           May 3, 2013
                                                                           US Interest Rate Strategist


Exhibit 4                                                                   Exhibit 5
Offside vs. Onside Positions in All Treasury                                Addition of Open Interest at Various Price Points in
Futures Contracts Added in the Past Sixty Days                              the FV Contract over the Past Sixty Days
(10-Y Equivs)                                                                 $ billion
                                                                               20                                                                 Current
  UL                                                                                                                                              Price
                                                                               15

                                                                               10
 US
                                                                                5
  TY                                                                            0

                                                                               -5
 FV
                                                                                                                     Shorts offside
                                                                              -10




                                                                                                   -1-183

                                                                                                            -1-111

                                                                                                                      -1-040

                                                                                                                                -0-286

                                                                                                                                         -0-215

                                                                                                                                                   -0-143

                                                                                                                                                             -0-072

                                                                                                                                                                      124-246

                                                                                                                                                                                +0-072
                                                                                        -1-25+
  TU


       -30             -10             10            30             50                           Longs                         Shorts                       Current Price
                  $ billion notional (10-year equivalents)
        Longs Onside      Longs Offside   Shorts Onside   Shorts Offside
                                                                            Source: Morgan Stanley Research, CFTC

Source: Morgan Stanley Research, CFTC




                                                                                                                                                                                         12
                                                                       MORGAN STANLEY RESEARCH


                                                                       May 3, 2013
                                                                       US Interest Rate Strategist



U.S. Treasury Inflation-Protected Securities
Inflation Insurance – Worthless?
Tiffany Wilding (212) 761-4415                                          approximately 30 basis points above the longest-dated
                                                                        forward measures, which priced at or near the Fed’s long-
                                                                        term goal (see Exhibit 2). Against a backdrop of falling core
     We believe the recent drop in 5y5y forward breakevens is
                                                                        PCE inflation and still weak real growth, investors appear to
      symptomatic of a decline in inflation risk premium priced
      into the breakeven curve. We do not believe the market is         be no longer willing to pay up for protection.
      pricing in a more ominous view on long-term Fed credibility.
                                                                        Exhibit 1
     US inflation markets have been focused on the core PCE
      disinflation, which has occurred despite continued central        5-year Forward 5-Year Breakeven
      bank unconventional policy actions. Hence, we analyze
                                                                           %
      past breakeven behavior around core PCE inflation                               Inf lation Projection Threshold
      troughs.                                                             3.0

     Our analysis suggests that breakevens have tended to fall
                                                                           2.5
      in response to core PCE disinflation 4 to 6 month prior to
      the trough. In each episode, central bank actions have
      resulted in a recovery in breakevens 2 to 3 months before            2.0                                                    Inf lation
      the trough.                                                                                                                 Target

     This time around 5y5y breakeven rates have not collapsed.            1.5
      We attribute this to more transparency around the Fed
      reaction function.                                                   1.0
     We can not rule out a messy TIPS market reaction to a
      further deterioration in economic data. Still we believe it is       0.5
      too early to bet on a long-term monetary policy miss.                 Jan 02 Jan 04 Jan 06 Jan 08 Jan 10 Jan 12
      Wednesday’s FOMC statement told us the Fed still has                                           5y5y Fw d Breakeven
      levers to pull. If the TIPS market needs shock and awe –
      we believe the Fed can deliver.                                   Source: Morgan Stanley Research, Bloomberg


                                                                        Exhibit 2
Forward Breakeven Rates – ‘Fair’ not ‘Cheap’
                                                                        10-Year Forward 20-Year Breakeven
Over the last several days, the decline in long-dated forward
breakeven rates has coincided with increased discussion                      %
around the ability of central bank policies to create growth                3.50
and inflation. US inflation markets have been focused on the                                                         Inf lation Target
                                                                                                                     Annoucement
core PCE disinflation, which has occurred despite continued
central bank unconventional policy actions. Still, we remain                3.00
skeptical that the market has is losing faith in the Fed’s ability
to reach its long-term inflation goal. To us the TIPS market is             2.50
                                                                                              Inf lation
merely suggesting that investors are no longer willing to pay
                                                                                              Target
a premium for inflation protection.
                                                                            2.00
Cash-based 5y5y forward breakeven measures are currently
trading at or close to the Fed’s 2% PCE long-term inflation                 1.50
goal – 2% PCE + a 50bp basis between PCE and CPI (see
Exhibit 1). If the Fed is credible, then rational expectations
                                                                            1.00
for long-term inflation should be anchored at that goal. This
                                                                               Jan 02          Jan 05          Jan 08       Jan 11
logic suggests that in the period after the QE∞                                                        10y20y Breakeven
announcement investors have were willing to pay-up for
inflation protection, especially in the intermediate sector of          Source: Morgan Stanley Research, Bloomberg
the curve – the 5y5y forward breakeven traded


                                                                                                                                               13
                                                                   MORGAN STANLEY RESEARCH


                                                                   May 3, 2013
                                                                   US Interest Rate Strategist


Interestingly, they are not willing to pay up for deflation         inflation fell approximately one percentage point before
protection either. The recently issued on-the-run 5-year TIPS       bottoming. The magnitude of the disinflation was very similar
is not pricing in any notable premium for the embedded near-        in each episode. The magnitude of the current bout of
the-money strike deflation floor option. The implied                disinflation (dark blue line) is also similar in magnitude to the
probability of deflation based on that bond is currently zero.      last three episodes. Core PCE does not appear to have
                                                                    bottomed yet, but based on recent experience it may be
Where Do We Go From Here?                                           close.
A natural question arises from our view that long-term
inflation expectations are still pricing to the Fed’s inflation     Exhibit 3
target is what causes credibility to deteriorate and longer-        Core PCE During Disinflationary Episodes
dated breakevens to fall. In our view, there are two channels
with which this could happen – (1) the Fed’s indicates that is          %
not willing to take further actions to fend off slow growth and        2.8
disinflation or (2) the market loses faith in the Fed ability to
create growth and inflation. We believe the FOMC continues
                                                                       2.3
to be committed to achieving its dual mandate. Moreover, we
still think it’s too early for the market to begin pricing an
inability of the Fed to reach its long-term inflation goal.            1.8

The Fed still has levers to pull. In the FOMC statement this
week, the committee affirmed that it is prepared to increase           1.3
or decrease the monthly pace of purchases, as warranted by
the economic situation. If the market begins to question the           0.8
ability of the Fed to achieve its long-term goal, as evidence
                                                                                12        8     4     0    -4     -8                    -12
by a further fall in long-dated TIPS breakevens, increasing                                Months around PCE Trough
the pace of purchases could provide the market with more                             Sep-03             Jul-09       Dec-10           Mar-13
support.
                                                                    Source: Morgan Stanley Research, Bloomberg

Breakevens Respond to Shock and Awe
The FOMC statement this week confirmed that the                     Exhibit 4
committee is ready and willing to increase or decrease the          5y5y Forward Breakeven Around Core PCE
pace of its purchases. After implementing the monetary              Troughs (2003, 2009 and 2010 Episodes)
policy threshold-based framework in December, the Fed put
                                                                         %
accommodation on auto pilot, letting the market adjust its
expectations for future Fed policies based on incoming                   3.50
economic data. This policy was designed to reduce monetary
                                                                         3.25
policy surprises and increase the transparency of the so
                                                                                              QE1 UST
called “Fed reaction function.” However, the Fed’s ability to            3.00
surprise the market – i.e., create shock and awe – is
sometimes exactly what the inflation market needs. Based                 2.75
on the recent past, TIPS breakevens respond to shock and
awe. In our view, the confirmation that the Fed can                      2.50                                    2003 Rate Cut
further increase the pace of purchases allows them to
retain the ability to further shock the inflation market.                2.25
                                                                                                                 2010 Jackson Hole

                                                                         2.00
Fed Actions Trump PCE Disinflation
                                                                                 8            6     4      2     0      -2               -4
Since the 1997 introduction of the TIPS product, core PCE
                                                                                               Months around PCE Trough
has realized three bouts of more prolonged disinflation. The
                                                                                     Jul-09               Dec-10            Sep- 03
first bout occurred in 2003 in the wake of the dotcom-related
crash, while the second and third bouts occurred doing the          Source: Morgan Stanley Research, Bloomberg

2008 and 2010 deflation scares, respectively. Exhibit 3
overlays these bouts of PCE disinflation, indexed around the        During these bouts of core PCE disinflation the behavior of
time the PCE realized a trough. During each bout, core PCE          5y5y forward TIPS breakevens has also been very similar.


                                                                                                                                               14
                                                                     MORGAN STANLEY RESEARCH


                                                                     May 3, 2013
                                                                     US Interest Rate Strategist


Indexing a time series of the 5y5y around the time of PCE             the Fed still has levers to pull. Shock and awe has worked in
trough illustrates this fact (see Exhibit 4). As the exhibit          the past, and we believe it will work again.
illustrates, breakevens fell approximately 50 to 75 basis
points 4 to 6 months before each of the three PCE troughs.            TIPS Aren’t Indexed to PCE Inflation
During each episode, monetary policy easing was the                   Up until now, we have discussed the reaction of the 5y5y
catalyst to the ultimate recovery in breakevens. What is more         breakeven around troughs in core PCE inflation. However,
interesting, the 5y5y forward breakeven measure had                   we should emphasize that TIPS inflation accruals aren’t
completely retraced approximately 2 months before the PCE             indexed to PCE; conversely, they are indexed to CPI.
inflation trough. In other words, after the central bank              Despite the core PCE behavior, core CPI has remained
accommodation, inflation markets tolerated 2 to 3 more weak           relatively stable over the past year.
inflation prints before core PCE started to accelerate.
                                                                      What is causing the divergence? The relative weight
Exhibit 5                                                             between PCE and CPI shelter components (18% and 42%,
5y5y Forward Breakeven Around Core PCE                                respectively) is the catalyst for some of the difference;
Troughs                                                               however, our economics team points out that non-market
                                                                      components – financial services, in particular – are driving
(2010 and Current Episodes)
                                                                      the rest. Based on their models, the relative difference
   %                                                                  between the shelter weights is driving approximately half of
                      QE∞ UST                                         the widening (0.3 percentage points) in the core PCE vs. CPI
 3.25
                                                                      basis, while the rest (0.2 percentage points) is driven by non-
                                                                      market components. Since these non-market components
 3.00                                                                 are not captured in the CPI baskets, the TIPS market should
                                                                      not directly price-in their disinflation.
 2.75
                                                                      Conclusions
                                                                      We believe the recent drop in long-dated forward breakevens
 2.50                                                                 is symptomatic of a decline in inflation risk premium priced
                                   2010 Jackson Hole                  into the breakeven curve. To us, the TIPS market is merely
 2.25                                                                 suggesting that investors are no longer willing to pay a
            QE∞ MBS
                                                                      premium for inflation protection and we do not believe the
 2.00                                                                 market is pricing in a more ominous view on long-term Fed
                                                                      credibility. It is still too early to believe that the Fed’s policies
            8       6      4      2     0                -2   -4
                                                                      are ineffective, and the Fed hasn’t yet signaled it is unwilling
                   Months around PCE Trough
                                                                      to provide further accommodation. Furthermore, if the market
                   Mar-13                       Dec-10
                                                                      does begin to question the ability of the Fed to achieve its
Source: Morgan Stanley Research, Bloomberg                            long-term goal, increasing the pace of purchases could
                                                                      provide the market with more support. The Fed can still
This Time Is Different?                                               achieve shock and awe.
Plotting the recent trend in 5y5y against the realized trend
around the December 2010 core PCE trough presents a
different story (we use the December 2010 episode as a
benchmark for the three periods analyzed). Similar to the last
three episodes, the central bank announced further monetary
policy actions to ease financial conditions approximately 4 to
6 months ahead of core PCE reaching its current low levels.
However, this time, the policy was not in response to a
collapse in TIPS breakevens. Although the current trend in
core CPI disinflation is similar in magnitude to the last three
episodes, 5y5y has been remarkably stable. We attribute
this stability to the market’s belief that the Fed is credible and
that this pricing should persist. If the market begins to
question the Fed’s credibility and forward breakevens fall,



                                                                                                                                       15
                                                                     MORGAN STANLEY RESEARCH


                                                                     May 3, 2013
                                                                     US Interest Rate Strategist



US Short Duration Strategy
Opportunities in the Front-end
Subadra Rajappa (212) 761-2983                                        Exhibit 1
                                                                      Primary Dealer Securities Holdings and GCF Repo
     Overnight repo cheapened into month-end but should               basis points                                               $billion
      decline with the continued reduction in bill supply. We
      expect repo to decline to the 8-15bp range over the              30                                                             200
      summer.
                                                                       25                                                             150
     We should get more clarity in the coming months on
      several key proposals to regulate systemically important         20                                                             100
      financial institutions, shadow banking activities and money
      market funds.                                                    15                                                             50
     New regulations could dramatically alter the money market
      landscape and supply demand dynamics in the repo                 10                                                             0
      markets.
                                                                        5                                                             -50
     As expected Treasury announced that it will gradually
      reduce Treasury bill and coupon issuance due to the              0                                                              -100
      dramatic increase in tax receipts in April.                      May-10           Feb-11           Nov-11       Aug-12
     We also got more clarity on the Treasury FRN program,                       GCF Repo (lhs)            PD Securities Holdings (rhs)
      the details to be finalized in the August refunding
                                                                      Source: Morgan Stanley Research, Bloomberg
      announcement.

     UST 2-year notes dipped below 20bps for the first time
                                                                      Exhibit 2
      since late 2011. We construct a simple model to determine
      fair value of 2y notes.                                         GCF Repo Spot and Futures
                                                                       basis points
Market Update                                                          30
Overnight repo cheapened into month-end (with large
Treasury coupon settlement on Tuesday) keeping repo in the             25
18-21bp range this week. Although there were no major
surprises in the Treasury refunding announcement, bill                 20
supply should continue to come under pressure. As we
highlighted last week the availability of collateral will continue     15
to be the key driver of repo during the summer months. So                                          Futures price-
                                                                       10
far despite Fed asset purchases (QE ∞) primary dealer                                              in rangebound
securities positions are on the rise, unlike past QE episodes           5                            repo rates
when they declined. The relationship between primary dealer
securities positions and overnight repo has also remained               0
intact (see Exhibit 1). GCF repo futures suggest an average             May-11        Nov-11         May-12        Nov-12   May-13
overnight repo rate of 12.5bp for May (see Exhibit 2). With
the decline in Treasury bill supply and bill rates at the lows,                        GCF Repo            GCF Futures
we expect repo rates to follow suit. We expect overnight repo         Source: Morgan Stanley Research, Bloomberg
to decline to the 8-15bp range over the summer.
                                                                      Regulation Nation
                                                                      Regulators across the globe are paying close attention to
                                                                      money markets and figuring out ways to mitigate systemic
                                                                      risks. As outlined in a recent paper, the Fed is closely
                                                                      tracking shadow banking activities to identify sources of



                                                                                                                                          16
                                                                                    MORGAN STANLEY RESEARCH


                                                                                    May 3, 2013
                                                                                    US Interest Rate Strategist


instability 4 . Over the coming months we should get more                                    allowed to accept collateral for repo trades with maturity
clarity on several key proposals to regulate systemically                                    greater than 397 days, which represents a majority of
important financial institutions, shadow banking activities and                              the collateral currently being posted to European money
money market funds (MMF) which could dramatically alter                                      funds. The draft proposal also suggest that European
the money market landscape and supply demand dynamics                                        money funds will not be able to use amortized cost
in the repo markets:                                                                         accounting and will not be allowed to be rated by rating
                                                                                             agencies. This could pose a severe blow to the €490bn
     The announcement of money fund reform proposals by                                     European money fund industry.
      the SEC is due this summer. The Financial stability
      oversight council (FSOC) comment period for MMF                                       Financial transaction tax (FTT). In mid-February a
      reform proposals ended on February 15. Market is                                       subset of 11 European countries (FTT-11) presented a
      waiting to hear on the future of MMF reform proposals                                  proposal to tax financial transactions. As we highlighted
      from the new SEC Chairman Mary Jo White and if she                                     last week, the implementation timeline is rather short
      will in fact propose floating NAV for MMFs 5 .                                         and the current proposal calls for FTT to go into effect
                                                                                             as of January 1, 2014. Although it is unlikely that FTT is
     The comment period for the Proposed Rule for                                           enacted in its current form, any tax on secondary
      regulating foreign banking organizations (FBO) ended                                   transactions with FTT-11 countries will be uneconomical
      on April 30. Based on the comments from market                                         and MMF will stop investing in them 9 .
      participants, we should get more information from the
      Fed on reforming FBOs. The proposals which are                                 Refunding Announcement – No Surprises
      intended to provide a consistent framework for                                 As expected Treasury announced that it will gradually reduce
      supervision of FBOs and their equivalent US                                    Treasury bill and coupon issuance due to the dramatic
      counterparts could increase capital and liquidity                              increase in tax receipts in April. The Deputy Assistant
      requirements for FBOs. Not surprisingly the rules are                          Secretary (DAS) Clark attributed the increase in tax receipts
      opposed by German and UK banks, which will need to                             to the expiration of “certain taxes” and the increase in capital
      shrink their balance sheets to meet these additional                           gains going into year-end 2012 ahead of the fiscal cliff fears.
      requirements. Our banking analysts think repo will be
      the single largest area that could be affected 6 .                             Bill Supply Should Continue to Decline

                                                                                     The Treasury did not make any changes to its Q2 borrowing
     The comment period for Notice of Proposed Rulemaking
                                                                                     needs, but indicated that “it may gradually decrease coupon
      on Financial Market Utilities introduced by the Federal
                                                                                     auction sizes”. We now estimate $22bn net pay-down in Q2,
      Reserve ends on May 3, 2013. Section 806(a) of the
                                                                                     $210bn in coupon issuance versus reduction in bill issuance
      Dodd-Frank Act (DFA) authorizes the Federal Reserve
                                                                                     coming from $127bn in weekly bills and $105bn in cash
      to establish accounts and provide certain financial
                                                                                     management bills (CMB). For Q3 our economists are
      services to financial market utilities (FMU) designated as
                                                                                     forecasting $245bn in net issuance versus Treasury’s own
      “systemically important” by the FSOC, while sections
                                                                                     forecast of $223bn. This would warrant continued reduction
      806(b) & 806(c) give the Fed the authority to potentially
                                                                                     in bill supply in the coming quarters (see Exhibit 3) in
      provide FMUs access to privileges currently available to
                                                                                     addition to $1bn or so reduction in coupon supply which
      other depository institutions, such as access to the
                                                                                     could start as early as August.
      discount window and the ability to earn interest on cash
      balances at the Fed. This could potentially impact FMU
      demand for money funds 7 .

     Global money fund reform proposals may turn out to be
      just as ambitious as the regulations proposed by
      regulators in the US. The draft proposal made available
      to the public outlines regulators concerns about constant
      NAV funds, proposing that they maintain a 3% cash
      buffer to absorb losses 8 . Money funds will also not be
4
  See Short-Duration Strategy – Monitoring Risks, March 8, 2013
5
  See Short Duration Strategy - Regulatory Hurdles, March 15, 2013
6
  See Short Duration Strategy – Tracking the Flows, April 5, 2013
7
  See Short Duration Strategy – Regulatory Hurdles, March 15, 2013
8                                                                                    9
  See financial times – Brussels plan will ‘kill off’ money funds, April 28, 2013        See Short Duration Strategy – Supply Matters, April 26, 2013


                                                                                                                                                        17
                                                                              MORGAN STANLEY RESEARCH


                                                                              May 3, 2013
                                                                              US Interest Rate Strategist


Exhibit 3                                                                      number on Friday moved 2-year yield back in the 20-30bp
Treasury Bill Issuance Estimate                                                range held since Q2-2012. Exhibit 4 shows a 3-year history
     Announce      Settle           Offered Amount         Maturing    New     of 2-year. We notice that 2-year yield dipped below 20bp in
        date        Date     4-wk      3m     6m     1y    Amount     Money    August 2011 over concerns that the Fed might cut IOER, but
      2-May        9-May      30       29      24           105        -22
                                                                               yields rose once those fears abated. In Q1-2012 2-year yield
      9-May       16-May      35       29      24           108        -20
      16-May      23-May      40       29      24           103        -10
                                                                               increased above 30bp when growth started to pickup but
      23-May      30-May      40       29      24    23     118         -2     came right back down when we hit the soft patch in Q2-2012.
      30-May       6-Jun      40       29      24            93          0     Even though bond yields rose this week with the stronger
       6-Jun      13-Jun      30       29      24            98        -15     than anticipated May employment data, 2-year yield currently
      13-Jun      20-Jun      30       29      24           103        -20
                                                                               at 21.7bp is still at the lows. So how low can yields go? We
      20-Jun      27-Jun      30       29      24    23     128        -22
      27-Jun        5-Jul     40       30      26           103         -7
                                                                               believe it is unlikely that 2-year yield stay below 20bps for a
        4-Jul      11-Jul     40       30      26            93          3     sustained period unless the market believes that the Fed will
       11-Jul      18-Jul     40       30      26            93          3     lower IOER.
       18-Jul      25-Jul     40       30      26    23     115          4

Source: Morgan Stanley Research, Bloomberg                                     Exhibit 4
                                                                               UST 2-year Yields
Treasury Floating Rate Notes
                                                                                basis points
The Treasury announced a tentative schedule and a
                                                                                100
potential structure of its floating rate note (FRN) program on
Wednesday. The Treasury Borrowing Advisory Committee                              90
(TBAC) minutes state that the Treasury “has decided to use                        80        QE2
                                                                                            begins              QE2         Q1-Q2
the weekly High Rate (auction clearing rate) of 13-week                           70
Treasury bill auctions as the index for Treasury FRNs” based                                                    ends         2012
                                                                                  60                                        growth
on comments received from market participants but that the
                                                                                  50                                         story
“Treasury remains open to studying alternative indices in the
future, should an obvious benchmark emerge”. We also got                          40                                                   20-30bp range
some clarity on other aspects of the program:                                     30         Market
                                                                                  20       concerned
When will issuance begin? As anticipated, the Treasury                            10       about IOER
stated that it plans to start issuing FRNs in Q4-2013 or Q1-                                  cut
                                                                                   0
2014.
                                                                                  May-10                 May-11               May-12          May-13
How much will they issue? The Treasury is considering                          Source: Morgan Stanley Research, Bloomberg

issuing $10-15bn per month, but they will firm up issuance
sizes based on feedback from market participants before the                    With the Fed expected to be on hold until mid-2015, the
first auction.                                                                 correlation between 2-year and most market variables has
                                                                               broken down over the last year. To better understand the
What tenors will they issue? The Treasury expects to issue a                   dynamics of 2-year yields and to discern fair value of the 2-
2-year FRN to start with. Addition of new structures and                       year we construct a simple multiple regression model (see
maturities down the line will depend on the success of initial                 Exhibit 5). 2-year are mainly driven by two market factors -
FRN program.                                                                   GCF repo and 2-year OIS. Based on these factors our model
                                                                               suggests that 2-year yields are 2.5bp too rich. With 2-year
When will they finalize the details? Details of the FRN                        close to the bottom end of the 20-30bp range held since
program including the terms of the trade will be finalized at                  early last year, we recommend underweighting 2-year at
the August refunding meeting. The draft term sheet is                          current levels. Going short 2-year has a negative carry of
available in the TBAC meeting presentation 10 .                                2.8bp for 3 months. Hence we recommend entering into
                                                                               2s/3s flattener. This trade has a positive carry of 1.5bp for 3
UST 2-year Yield – How Low Can It Go?                                          months. If the soft patch in the second quarter persists we
This week 2-year dipped below 20bps for the first time since                   can expect 2s/3s to flatten from current level of 11bp (see
late 2011 with slowdown in the economy this quarter.                           Exhibit 6). The risk is if bonds continue to sell off and the
However the sell off in bonds after the strong employment                      2s/3s curve steepens further from here.

10
     See TBAC Discussion Charts for 2nd Quarter, 2013 pages 47-49.


                                                                                                                                                  18
                                                                   MORGAN STANLEY RESEARCH


                                                                   May 3, 2013
                                                                   US Interest Rate Strategist


Exhibit 5
                                                                    Exhibit 6
UST 2-year Yield versus Model                                       UST 2s/3s Curve
 basis points
                                                                     basis points
 32
                                                                     18
 30
                                                                     16
 28
                                                                     14
 26
                                                                     12
 24
                                                                     10
 22                                               2.5bp
                                                                       8

 20
                                                                       6
  May-12           Aug-12         Nov-12      Feb-13      May-13
                                                                      May-12           Aug-12           Nov-12   Feb-13   May-13
                           UST2y      Model
                                                                    Source: Morgan Stanley Research, Bloomberg

Source: Morgan Stanley Research




                                                                                                                              19
                                                                     MORGAN STANLEY RESEARCH


                                                                     May 3, 2013
                                                                     US Interest Rate Strategist



USD Interest Rate Derivatives: Swaps
Treasury Issuance and Spreads
Mikhail Levin (212) 761-8556                                         Exhibit 1
Ankur Shah (212) 761-1909                                            Treasury Bill Issuance and 2-Year Spreads*
                                                                       Bill Issuance ($bn)                                     2y Spread (bp)
     We discuss swap spreads in the context of recent
                                                                      900                                                                        200
      changes to Treasury bill issuance and the Treasury
      refunding announcement.                                                                                                                    180
                                                                      800
                                                                                                                                                 160
     Front-end spreads tend to be driven by a combination of
                                                                      700                                                                        140
      repo rates and LIBOR. To the extent that changes in
      supply affect repo rates, we would expect front-end             600                                                                        120
      spreads to move. However, we do not foresee a large                                                                                        100
      short term impact to front-end spreads from changes in          500                                                                        80
      issuance.
                                                                      400                                                                        60
     At the back-end of the spread curve, the drivers of spread                                                                                 40
      moves are much more complex. However, over long time            300
                                                                                                                                                 20
      periods, a strong correlation between the fiscal deficit and
      spreads exists.                                                 200                                                                        0
                                                                        2008          2009         2010       2011        2012           2013
     Treasury futures have experienced a dramatic increase in
      open interest as Dodd-Frank regulation and clearing
                                                                                             Bill Issuance              2y Spread
      mandates moved into place.
                                                                     *CMT Spreads
                                                                     Source: Morgan Stanley Research
Treasury Issuance and Spreads
With the recent increase in tax receipts and the corresponding       Instead, we attempt to understand the changes in front-end
decline in this year’s budget deficit, the Treasury has begun to     spreads by looking at what we believe are the main drivers,
lower the amount of Treasury bill issuance and has discussed         bank and Treasury funding conditions. Regressing spreads on
the possibility of lowering Treasury coupon issuance in the          3-month LIBOR rates and the DTCC’s GCF repo index since
future.                                                              November 2009 (as far back as the repo index goes) these
                                                                     variables have significant coefficients, with the regression
We analyze the impact of supply from a historical perspective        having a relatively high r-squared (Exhibit 2). As we would
to understand the drivers of this widening. Fundamentally, the       expect, the regression suggests that higher LIBOR rates lead
argument goes that lower Treasury supply should drive yields         to wider spreads, and higher repo rates lead to tighter
lower relative to other duration instruments as demand for           spreads.
securities outweighs supply, leading to a widening in spreads.

                                                                     Exhibit 2
While this is a persuasive argument, it is difficult to parse out
                                                                     Regression Statistics for 2- and 5-Year Spreads*
this argument historically given the different macro factors that
                                                                     2-Year Spreads                    Since 11/2009       2y History           1y History
drive moves in spreads and Treasury issuance over time.              Beta on LIBOR                              0.59              0.75               0.79
However, looking at front-end spreads may lend clarity given         Standard Error                             0.02              0.03               0.03
                                                                     Beta on GCF Repo                          -0.55             -0.76              -0.29
that there are fewer idiosyncratic drivers in the front-end.         Standard Error                             0.03              0.03               0.04
                                                                     R2                                         46%               72%                70%
                                                                     5-Year Spreads                     Since 11/2009      2y History           1y History
Front-End Spreads                                                    Beta on LIBOR                               0.24             0.48               0.58
                                                                     Standard Error                              0.02             0.02               0.04
Exhibit 1 displays a history of Treasury bill issuance and 2-                                                   -0.56            -0.66              -0.26
                                                                     Beta on GCF Repo
year spreads. Issuance and spreads may both be driven by             Standard Error                              0.03             0.03               0.05
                                                                     R2                                          32%              62%                52%
exogenous factors–in 2008, poor economic conditions led to
                                                                     *CMT Spreads
larger debt issuance and deteriorating bank funding conditions       Source: Morgan Stanley Research, DTCC
causing spreads and issuance to move in the same direction.
Because of such factors little causality can be gleaned from         The association between repo rates and front-end spreads
this chart.                                                          suggests that to the extent that changes in Treasury issuance


                                                                                                                                                      20
                                                                                                      MORGAN STANLEY RESEARCH

                                                                                                      May 3, 2013
                                                                                                      US Interest Rate Strategist




affect repo rates, we should expect that spreads would widen.                                         narrowed because of higher government spending and lower
However, given the already low level of expected repo rates                                           revenues, while spreads tightened due to exotic note hedging
based on GCF futures, we do not see much room for repo to                                             and receiving demand.
fall further. Therefore, we do not anticipate much more
widening in front-end spreads as a result of the decrease in                                          Exhibit 4
Treasury issuance.                                                                                    Fiscal Deficit and 30-Year Swap Spread History
Longer-Dated Spreads                                                                                    Deficit/GDP (%)                          30-Year Swap Spread (bp)
Over the past several months, we have held a fundamental                                                  4                                                              145
back-end spread widening view. After this year’s move wider,                                              2                                                              125
we decided to turn tactically neutral on spreads; however, we                                                                                                            105
continue to hold a fundamental back-end spread widening                                                   0
                                                                                                                                                                         85
view over the longer term.                                                                               -2                                                              65
Looking at longer-dated spreads in the context of our original                                           -4                                                              45
discussion, Exhibit 3 displays the variables that are                                                    -6                                                              25
correlated with spreads. As we discussed above, front-end                                                                                                                5
spreads tend to be correlated with repo rates and LIBOR.                                                 -8
                                                                                                                                                                         -15
However, back-end spreads tend to have less significant                                                -10                                                               -35
correlations, and these correlations are more prone to
changing over time.                                                                                    -12                                                            -55
                                                                                                          1993             1998           2003        2008        2013
Exhibit 3                                                                                                            Fiscal Deficit/GDP                30YSw ap Spread
Correlations Between Spreads and Other Factors*
                                                                                                      Source: Morgan Stanley Research
                               3m           GCF           Bill            Coupon           Deficit/
2-Year Spreads              LIBOR          Repo      Issuance          Issuance**            GDP
2003-2013                     +          N/A            X                 -                 +
2004-2007                     +          N/A            X                 -                 +
                                                                                                      Similarly, the recent move upward in both trends does not
2010-2013                     +           -             X                 +                 -         appear to follow a causal path. As we have discussed
                               3m           GCF           Bill            Coupon           Deficit/
5-Year Spreads              LIBOR          Repo      Issuance          Issuance**            GDP
                                                                                                      previously, spreads have widened due to Dodd-Frank, equity
2003-2013                     +          N/A            X                 -                 +         outperformance, and exotic hedging, not primarily as the
2003-2007                     +          N/A            X                 -                 +
2010-2013                     +           -             -                 X                 -
                                                                                                      result of lower deficits.
                               3m           GCF           Bill            Coupon           Deficit/
10-Year Spreads             LIBOR          Repo      Issuance          Issuance**            GDP
2003-2013                     +          N/A            -                 -                 +
                                                                                                      To the extent that there is some causal relationship between
2003-2007                     +          N/A            X                 -                 +         deficits/Treasury issuance and 30-year spreads, we believe it
2010-2013                     X           -             -                 X                 +
                               3m           GCF           Bill            Coupon           Deficit/
                                                                                                      holds primarily over longer periods rather than in the short or
30-Year Spreads             LIBOR          Repo      Issuance          Issuance**            GDP      medium term. Therefore, we discount the possibility that lower
2003-2013                     +          N/A            -                 -                 +
2003-2007                     +          N/A            +                 X                 +
                                                                                                      than expected deficits over the next few months will be the
2010-2013                     X           X             X                 X                 X         driver of significantly wider spreads unless there are
                               3m           GCF           Bill            Coupon           Deficit/
5s/30s Spread Curve         LIBOR          Repo      Issuance          Issuance**            GDP
                                                                                                      fundamental changes in longer term deficit expectations.
2003-2013                     +          N/A            -                 -                 +
2003-2007                     +          N/A            -                 X                 X         Spreads and QE
2010-2013                     -           +             X                 X                 X
*X represents an insignificant correlation. +/- represent a positive/negative correlation. N/A is     While looking at changes in spreads around QE
listed for GCF repo where data was not available. **Net of Fed Purchase Programs
Source: Morgan Stanley Research,                                                                      announcements is difficult given the multitude of factors in
                                                                                                      play, we attempt to discern some general trends around
One variable that does tend to move in line with back end                                             announcement dates. Exhibit 5 displays the performance of
spreads is the deficit/GDP Ratio. Exhibit 4 displays the long-                                        spreads in the week after various FOMC announcements.
term history of the US fiscal deficit and 30-year swap spreads.
While the two series have tracked each other broadly, we do                                           The most significant effects are visible in 7- and 10-year
not believe that changes in the deficit and the resulting                                             spreads, with tightenings after each QE announcement. This
change in Treasury issuance caused many of the moves in                                               may be the result of outperformance in mortgages after QE
spreads. In 2008, as the economy deteriorated, the deficit                                            announcements driving spreads tighter.

                                                                                                                                                                             21
                                                                                          MORGAN STANLEY RESEARCH

                                                                                          May 3, 2013
                                                                                          US Interest Rate Strategist




Exhibit 5                                                                                 TY open interest increased since the beginning of the year,
Spread Moves in Week After QE Announcements                                               growing significantly above past contract open interest as
Announcement                2-Year        5-Year       7-Year      10-Year      30-Year   Dodd-Frank regulation progressed.
QE1-Mortgage                  -1.8          -6.3         -1.1           -10.8      -1.9
QE1-Treasury                  -3.5         -13.5         -5.3            -6.3      -1.8
QEII*                          1.9           0.2         -2.7            -1.8       1.2
MEP                           -0.7           0.4         -3.7            -4.2      -3.4   Exhibit 7
QE∞                           -0.2          -2.9         -5.7            -6.4      -4.1   US Future Open Interest
Average                       -0.8          -4.4         -3.7            -5.9      -2.0
Standard Error                 0.9           2.6          0.8             1.5       0.9     Open Interest (Thousand Contracts)
*This is the Jackson Hole Speech, not the official announcement date.
Source: Morgan Stanley Research
                                                                                           800

However, we caution that these results may not be robust.                                  700
They are based on only five data points, they are sensitive to                             600
the chosen time period around QE announcements (in
                                                                                           500
particular the impact on the 7-year spread disappears if we
use any more than five days), and finally, if we were to use                               400
the official QEII announcement rather than Bernanke’s                                      300
Jackson Hole speech, the 7- and 10-year effects disappear.
                                                                                           200
Moving to Treasury Futures                                                                 100
Over the past few months, we have discussed how Dodd-                                          0
Frank regulations would likely push investors out of OTC
                                                                                                150                   100             50              0
swap trading and into other products such as Treasury                                                                Days to Expiry
futures. Now that initial clearing mandates have been put into                                          USM3                          USH3
place, and broader clearing mandates are approaching                                                    USZ2                          USU2
quickly, Treasury futures have begun to experience an                                                   Clearing Mandate              Today
increase in trading.                                                                      Source: Morgan Stanley Research


Exhibit 6 and Exhibit 7 display the open interest in the                                  The trend in the US and Ultra contract is even more evident
current front month TY and US Treasury futures contract                                   (the Ultra chart looks similar to the US chart). Beginning very
relative to past contracts.                                                               near to the OTC swap clearing mandate, open interest in
                                                                                          these contracts began to increase as increased swap trading
Exhibit 6                                                                                 costs likely pushed market participants into cheaper
TY Future Open Interest                                                                   alternatives.
  Open Interest (Thousand Contracts)
                                                                                          These exhibits present some of the best evidence thus far that
 2,500                                                                                    Dodd-Frank has in fact moved volume towards Treasury
                                                                                          futures, with clearing mandates having particularly clear effect
 2,000
                                                                                          on longer tenors.
 1,500
                                                                                          Swap Data Update
 1,000                                                                                    Here is this week’s breakdown of swap and Swaption trades
                                                                                          reported to the DTCC’s swap data repository:
    500

        0
         150                         100            50                              0
                                     Days to Expiry
                 TYM3                                        TYH3
                 TYZ2                                        TYU2
                 Clearing Mandate                            Today
Source: Morgan Stanley Research



                                                                                                                                                          22
                                                                                          MORGAN STANLEY RESEARCH

                                                                                          May 3, 2013
                                                                                          US Interest Rate Strategist




Exhibit 8
                                                                                          Exhibit 9
Weekly SDR Swap Volume*                                                                   SDR Swap Volume History*
Notional $bn        1Y      2Y      3Y      5Y      7Y    10Y      20Y     30Y    Total
Spot                3.2   13.1    20.7    61.2    18.5    54.2      4.5   11.3 186.8        Average Daily Volume by Week ($bn)
3m                  0.7    2.2     0.2     3.7     0.7     1.7      0.3    0.0   9.5
6m                  0.6    0.6     0.0     0.7     0.5     2.2      0.2    0.4   5.2
                                                                                           85
1y                  1.0    0.6     0.0     0.5     0.7     1.4      0.0    0.3   4.5
2y                  0.4    1.6     0.6     1.6     0.2     0.3      0.0    0.0   4.9       80
3y                  2.1    0.0     0.0     0.7     0.0     0.4      0.0    0.2   3.4       75
5y                  1.0    0.6     0.2     2.2     0.0     0.4      0.0    0.0   4.4       70
10y                 0.2    0.4     0.0     0.0     0.0     1.2      0.1    0.0   1.8
                                                                                           65
Total Non-Spot      5.9    6.0     1.0     9.3     2.1     7.6      0.6    1.0 33.5
Total               9.1   19.1    21.8    70.5    20.6    61.8      5.1   12.2 220.3       60
*Volumes include USD 3m Libor Interest Rate swaps traded between April 26, 2013 and May    55
2, 2013 and reported to the DTCC’s SDR. Capped notionals are estimated.
Source: Morgan Stanley Research, DTCC                                                      50
                                                                                           45
                                                                                           40
                                                                                             Jan-       Jan- Feb- Feb- Mar- Mar- Apr- Apr- May-
                                                                                              11         25   08   22   08   22   05   19   03

                                                                                                                       Week Ending

                                                                                          *Volumes include USD 3m Libor Interest Rate swaps reported to the DTCC’s SDR.
                                                                                          Source: Morgan Stanley Research, DTCC




                                                                                                                                                                          23
                                                                                                        MORGAN STANLEY RESEARCH


                                                                                                        May 3, 2013
                                                                                                        US Interest Rate Strategist




Appendix
In US Interest Rate Strategist: A New Hope, March 8, 2013,                                              RDC and relative value factors. The trades the optimizer
we introduced our trade optimizer, which takes outright                                                 selects are presented below, with the ones we find most
duration trades in swaps and finds alternative trades based on                                          attractive highlighted in gray.
Trade Selection Results
                                                                      Regression           Total                                                                           Regression          Total
                                                     Excess 3m         Deviation         Pickup                                                           Excess 3m         Deviation        Pickup
Trade                     Time      Correl      Beta  RDC ($K)              ($K)            (SD)     Trade                     Time      Correl      Beta  RDC ($K)              ($K)           (SD)
2-Year Pay Fixed                                                                                     10-Year Pay Fixed
2y/10y Spread                1y      -0.81      -1.3          130             344           1.0                                  1y       0.87        1.7         -436           1421            1.4
Curve Flattener             3m       -0.77      -0.5          184            -258          -0.5      Short 5Y UST               3m        0.96        1.1          -38           -193           -0.9
3y/10y Spread                1y      -0.77      -1.3           23             210           0.4                                  1y       0.95        0.9           -52            585           1.3
Curve Flattener             3m       -0.75      -0.5          145            -266          -0.8      Short 10Y UST              3m        0.98        0.7          114            -142          -0.2
                             1y       0.92       1.1          193              -98          0.3                                  1y       0.92        0.8          482             148           1.2
Short ED1                   3m        0.68       0.9          196            -305          -0.6      Short 30Y UST              3m        0.98        0.7          490            -127           2.2
                             1y       0.99       0.9           78              -64          0.1                                  1y       0.93        1.1         -231             766           1.1
Short ED4                   3m        0.87       0.7          103            -142          -0.3      Short 7Y UST               3m        0.97        0.8           38            -271          -1.1
                             1y       0.98       0.9          120            -116           0.0      Pay 2y Forward 2y           1y       0.79        0.9         -155             674           0.6
Short ED2                   3m        0.64       0.6          151            -298          -0.8      Swap                       3m        0.98        1.0         -271             -89          -2.1
2-Year Receive Fixed                                                                                 10-Year Receive Fixed
5Y Spread                    1y       0.89       1.2           -61          1093            2.8      ED8/ED16 Curve              1y       0.95        1.1          340             632           2.3
Tightener                   3m       -0.15      -0.2         -238            483            1.0      Flattener                  3m        0.91        1.4          646             277           2.4
7Y Spread                    1y       0.82       1.0         -225           1211            2.1      2y/5y Swap Curve            1y       0.96        1.9          443             374           2.0
Tightener                   3m       -0.46      -0.3         -210            419            1.0      Flattener                  3m        0.96        1.9          415             363           2.9
                             1y       0.94       1.2         -199             700           1.7      3M Forward 2y/5y             1y       0.95       1.9          383             440           1.9
3Y Spread
                                                                                                     Swap Curve
Tightener                   3m        0.60       1.1         -200             444           1.3
                                                                                                     Flattener                  3m        0.95        1.9          392             379           2.9
5Y Forward                   1y      -0.90      -1.9          357             237           1.6
10y/30y Swap                                                                                         3y/5y Swap Curve            1y       0.96        2.9          406             349           1.8
Curve Steepener             3m       -0.42      -0.9           54             359           1.9      Flattener                  3m        0.96        2.8          375             355           3.0
5Y Forward                   1y      -0.89      -1.3          376             121           1.3                                  1y       0.91        1.9          428             557           1.7
                                                                                                     ED8/ED12 Curve
7y/30y Swap
                                                                                                     Flattener                  3m        0.83        2.6          928             291           2.4
Curve Steepener             3m       -0.53      -0.8          141             309           2.2
5-Year Pay Fixed                                                                                     30-Year Pay Fixed
                                                                                                                                 1y       0.97        1.2         -162           1386            2.3
                             1y       0.92       1.2          283             329           1.6
                                                                                                     Short 30Y UST              3m        0.99        0.8           -8            -21           -0.2
Short ED8                   3m        0.89       1.2          262             -40           0.7
                                                                                                                                 1y       0.93        1.3         -914           1984            1.4
                             1y       0.95       1.1          145             276           1.4
                                                                                                     Short 10Y UST              3m        0.97        0.8         -409            -76           -1.9
Short ED9                   3m        0.90       1.1          154              17           0.6
                                                                                                                                 1y       0.89        1.6        -1136           2211            1.1
Pay 1m Forward               1y       0.96       1.1          226             111           1.2
                                                                                                     Short 7Y UST               3m        0.94        0.9         -481           -235           -2.2
2y Swap                     3m        0.99       1.3           77              60           1.9
                                                                                                     Pay 1y Forward 7y           1y       0.78        1.2         -812           1418            0.5
                             1y       0.86       1.1          374             217           1.2
                                                                                                     Swap                       3m        0.98        1.0         -650             67           -2.7
Short ED7                   3m        0.81       1.3          281            -208           0.2
                                                                                                     5Y Forward                   1y       0.74       1.5         1285            -745           0.4
                             1y       0.78       1.0          573             112           1.1      2y/10y Swap
Short ED6                   3m        0.76       1.4          443            -290           0.4      Curve Steepener            3m        0.27        1.9        1521           -1887           -0.4
5-Year Receive Fixed                                                                                 30-Year Receive Fixed
                             1y       0.83       4.0          338             551           1.6      Long 5y on                   1y       0.79      10.9         1471           1048            1.9
Long 5y on
                                                                                                     2y/5y/7y Spread
2y/5y/7y Swap Fly           3m        0.92       3.5          200             439           2.5
                                                                                                     Fly                        3m        0.19        5.3          545           2109            2.7
Long 7y on                   1y       0.81       3.4          121             666           1.4
3y/7y/10y Swap                                                                                       2y/10y Swap                 1y       0.99        1.3          434             178           1.7
Fly                         3m        0.96       3.7          218             191           2.3      Curve Flattener            3m        0.98        1.4          459             123           2.7
ED8/ED12 Curve               1y       0.73       1.0         -179           1068            1.3      2y/3y Spread                1y        0.74      15.1          857           1522            1.6
Flattener                   3m        0.80       1.8          339            231            1.5      Curve Flattener            3m        -0.39      -8.1         -949           1548            0.6
                             1y       0.91       0.5           -23            492           1.2      3M Forward 2y/7y             1y       0.97       1.9          896            -106           1.6
                                                                                                     Swap Curve
Long ED15                   3m        0.90       0.6            83             61           0.5
                                                                                                     Flattener                  3m        0.96        1.6          740             196           3.3
                             1y       0.93       0.6            -2            410           1.1
                                                                                                     Receive 3m                  1y       1.00        1.0             4             11           1.5
Long ED14                   3m        0.89       0.7           91              54           0.5
                                                                                                     Forward 30y Swap           3m        1.00        1.0             5              2           1.5
These trades do not represent our recommendations. Please see our trade summary elsewhere in this report. *Treasury and Spread analysis based on CMT rates. RDC and regression deviation
based on 100K of PV01 for the equivalent swap curve trade. Total pick-up is basis points of RDC+ regression deviation, all in terms of the standard deviation of the regression. Data as of May 2,
2013. Source: Morgan Stanley Research




                                                                                                                                                                                                 24
                                                                         MORGAN STANLEY RESEARCH


                                                                         May 3, 2013
                                                                         US Interest Rate Strategist



USD Interest Rate Derivatives: Volatility
Gamma: The Price Is Right
Ankur Shah (212) 761-1909                                                 Exhibit 1
                                                                          Weekly Change in Normalized Vols*
          We have revised our thinking around the Evans rule, and
           believe it is depressing realized volatility. Economic           Vol Change (normal bp)
           volatility does flow through into higher realized rate           4
           volatility, but at the cost of reducing realized volatility
           around major policy events. We simulate the hypothetical
                                                                            3
           impact of economic data using the Bloomberg US
           Economic Surprise index, and find that the Evans rule
                                                                            2
           may have depressed realized volatility by 13% – inline
           with the observed decrease in realized vol.
                                                                            1
          The surprisingly positive NFP report gave gamma a boost.
           However, gamma remains close to historically low levels.         0
           Absent a significant increase in rates, we expect gamma
           to remain low. Comparing US vols and rates to JPY               -1
           markets shows that the US experience continues to track
           the JPY precedent. We believe 10-year swap rates would
                                                                           -2
           need to break above 2.2% for 3m10y implied vols to
           sustainably stay above 80 normal bp.
                                                                                         2y                  5y                     10y         30y

          We continue to like trades with high rolldown and carry,                   3m       6m       1y      2y       5y
           and recommend entering triangle trades by buying
                                                                          * Changes calculated from April 26, 2013 to May 3, 2013
           receivers on the 6m5y and 6m5y5y against selling 6m10y         Source: Morgan Stanley Research, Bloomberg
           receivers. The 6m10y and 6m5y5y receivers are struck
           OTM in order to deliver better carry and protect against a
                                                                          Exhibit 2
           bull flattening. This limited downside structure has a
                                                                          3m10y Implied Normal Volatility
           payout ratio of 3.2x, and is attractive against comparable
           triangles.                                                       Normal Vol (bp)
                                                                           250
Gamma rebounded after a sluggish start on the back of a
                                                                                                  3m 10y vols are near
surprisingly positive NFP report (see Exhibit 1). However,
                                                                           200                    their historical low s
Exhibit 2 shows that gamma remains dangerously close to
its lowest levels historically.
                                                                           150
Will Gamma Rally Back?
In our opinion, the answer is no, unless rates break
significantly higher. Exhibit 3 plots 3m10y implied vols                   100
against 10-year swap rates, for both US and JPY currencies.
Although not our base case, the chance of US volatility
                                                                             50
falling below JPY volatility is creeping higher – a risk we
highlighted in our top ten surprises for 2013 11 . The plot
shows how US markets are following the same trajectory of                       0
JPY markets – and the potential for vol to decline further if                   Jan 97      Jan 00       Jan 03       Jan 06         Jan 09   Jan 12
rates fall. The JPY experience suggests that if 10-year rates
fall below 1.5% then 3m10y implied vols could decline to new              Source: Morgan Stanley Research

historical lows below 50 normal bp.
                                                                          We have documented the rate / vol relationship in the past,
                                                                          and believe it is primarily driven by the relationship between

11
     See US Interest Rate Strategist: Top 10 Surprises for 2013


                                                                                                                                                       25
                                                                            MORGAN STANLEY RESEARCH

                                                                            May 3, 2013
                                                                            US Interest Rate Strategist




term premiums and implied vols. Our prior analysis 12 shows                  Index 13 going back to September 2011, when the Fed
how term premiums have been historically correlated with                     announced the Maturity Extension Program (MEP). The
the level of implied vol (see Exhibit 4). Over the past year,                thicker green bars represent changes in the index on days
vols have drifted lower relative to term premium, and the                    when there was (1) an FOMC announcement or (2) a NFP
term premium / vol relationship has weakened. We believe                     report, while the thinner red bars represent changes on other
that term premiums, and consequently 10-year swap rates,                     days.
would need to break significantly higher – above 2.2% – for
vol to rally above 80 normal bp.                                             Exhibit 4
                                                                             3m10y Actual and TP-Estimated Implied Vols
Exhibit 3
                                                                                  Vol (normal bp)
Historical USD and JPY 10-Year Swap Rates and
3m10y Implied Volatilities                                                    250
                                                                                              Term prem ium s are
     3m10y Normal Vol (bp)                                                                    historically w ell correlated
                                                                              200             w ith vol - but the relationship
     160          Current US yield and vol                                                    is starting to break dow n
                  levels are consistent w ith the
     140
                  JPY m arket 5 years ago...                                  150
     120
                  …and vol m ay fall
     100          further if rates                                            100
                  continue to decline
      80
                                                                                  50
      60
      40
                                                                                   0
                                                US - Sep 2011 to current
      20                                                                           Jan 97     Jan 00      Jan 03   Jan 06    Jan 09   Jan 12
                                                JPY - May 2008 to current
        0                                                                                 3m10y Implied Vol             TP Estimate of 3m10y Vol
            0.0      0.5       1.0       1.5           2.0   2.5      3.0    Source: Morgan Stanley Research
                           10-Year Swap Rate (%)
Source: Morgan Stanley Research
                                                                             Hypothetically, we assume that for each 0.01 change in the
                                                                             index value, the swap curve should move 1bp lower. In the
Rethinking the Evans Rule Impact on Vol                                      post-Evans rule framework, we assume markets can fully
The December 2012 FOMC statement explicitly linked the                       translate economic data into curve impact. As a result, the
liftoff date to economic thresholds. We have previously                      yellow line shows how the swap curve evolves due to newly
asserted that these thresholds, commonly referred to as the                  available economic data.
Evans rule for Chicago Fed President Charles Evans, were
bullish for volatility. Our logic was simple: changes in                     In a pre-Evans rule framework, markets only partially reprice
economic data would cause markets to adjust expectations                     rates based upon the economic data – at an assumed rate of
of the liftoff date, and accordingly drive the yield curve.                  20%. However, on a major news event, market expectations
                                                                             are fully recalibrated, meaning that rates adjust to “catch up”
However, we no longer believe the Evans rule is net bullish                  the backlog of data. The blue line shows how, in a pre-Evans
for volatility. While we still expect rates to adjust more                   rule framework, rates could generally be less volatile, but
quickly to changing economic data, these changes come                        would exhibit sharper moves on key events.
at the expense of lower volatility around FOMC
announcements.                                                               Under this simulation, realized volatility was 13% lower
                                                                             due to the Evans rule. As the exhibit shows, economic data
Exhibit 5 depicts how this works. The bars represent the                     tends to trend over time. As a result, an immediate repricing
daily change in the Bloomberg US Economic Surprise                           of data is naturally less volatile than a delayed repricing. For
                                                                             this reason, we like using an economic surprise index as a

12                                                                           13
     See US Interest Rate Strategist: Mambo Italiano                              ECSURPUS Index <GO> on Bloomberg


                                                                                                                                                   26
                                                                     MORGAN STANLEY RESEARCH

                                                                     May 3, 2013
                                                                     US Interest Rate Strategist




baseline for our data, since it will best reflect the balance of      trend and noise in economic data.

Exhibit 5
Hypothetical Rate Movement Pre- and Post- Evans Rule Due to Economic Data Shocks
     Shock (bp)                                                                                           Hypothetical Swap Rate (%)
       40                                                                                                                        3.5
                             Econom ic Shock (LHS)
                                                                                   The post-Evans' rule path is 13% less
                             FOMC or NFP Day (LHS)                                 volatile since the m arket can gradually
       30
                             Pre-Evans Rule (RHS)                                  adjust to changing data
                             Post-Evans Rule (RHS)
       20                                                                                                                        3

       10

        0                                                                                                                        2.5

      -10

      -20                                                                                                                        2

      -30

      -40                                                                                                                        1.5
        Sep-11         Nov-11          Jan-12   Mar-12    May-12   Jul-12       Sep-12         Nov-12     Jan-13       Mar-13

Source: Morgan Stanley Research, Bloomberg


Interestingly, our results largely match recent realized vol          We expect gamma to continue to stay low, due to low
performance. Since the Evans rule was introduced, 10-year             realized volatility. As such, we continue to recommend trades
rates have realized 58.6 normal bp, while the six-months              with high levels of rolldown and carry (RDC) with limited
prior to the Evans rule realized at 69.0 normal bp – implying         downside in the event rates move significantly.
a 15% change due to the Evans rule. The Evans rule may
also be partially responsible for the divergence between term         Trade Idea: 6m5y5y Triangle
premiums and implied volatilities seen in Exhibit 4.
                                                                           Buy $100mm 6m5y ATMF receivers (1.00% strike)
                                                     st
In our view, the changed language in the May 1 FOMC
                                                                           Sell $100mm 6m10y 20bp low receivers (1.77% strike)
statement – which added the sentence (our emphasis
added) “The Committee is prepared to increase or reduce
                                                                           Buy $100mm 6m5y5y 38bp low midcurve receivers
the pace of its purchases…” 14 – is unlikely to boost vol
                                                                            (2.66% strike)
higher. The changed language has reminded the market of
how the Fed can adjust monetary policy. Although the April
                                                                           Pay 29bp upfront to enter, hold trade to expiry
NFP report has reduced the need for the Fed to increase the
pace of purchases, it is indicative of the Fed’s ability to
                                                                      High Payout with Positive RDC
increase transparency of potential actions. The increased
transparency of potential Fed tools may increase market               If rates are unchanged at expiry, then the 6m10y and
reaction to economic events, but will lower it over FOMC              6m5y5y both expire OTM worthless. The 6m5y rate rolls
announcements, and in general lower overall realized vol.             down by 19bp from 1.00% to 0.81%, and would be worth
                                                                      about $938k at expiry. Compared to the initial cost of 29bp
                                                                      upfront, the trade has a 3.2x payout ratio. Exhibit 6 graphs
                                                                      the trade’s PnL, under different curve scenarios over time,
14                                                                    assuming rates move in parallel. If rates rise by 13bp or fall
     See FOMC Statement


                                                                                                                                 27
                                                                              MORGAN STANLEY RESEARCH


                                                                              May 3, 2013
                                                                              US Interest Rate Strategist


30bp from spot, the trade hits the breakeven level, and hits                   13bp running on the 10y swap. The net PnL, using the
the maximum loss if rates fail to decline from the forwards.                   current PV01s of 4.90 and 9.29, is about $865k.

The trade is also exposed to a bull flattening of the curve. If 5              Exhibit 7
and 10-year rates fall in a 1:1.34 ratio (based upon the ratio                 Triangle RDC and Risk-Adjusted RDC
of 6m5y to 6m10y implied vols), then the trade breaks even if                    Trade                            RDC (bp upfront)              Risk-Adjusted RDC*
5 and 10-year rates rise or fall by 13bp and 17.5bp                              6m3y5y                                       16.2                             0.26
respectively.                                                                    6m3y7y                                       34.3                             0.56
                                                                                 6m3y10y                                      34.3                             0.55
                                                                                 6m3y30y                                      34.3                             0.60
Exhibit 6                                                                        6m5y7y                                       42.7                             0.66
Trade PnL Across Parallel Rate Scenarios and Time                                6m5y10y                                      93.7                             1.47
                                                                                 6m5y30y                                      93.7                             1.63
 PnL (bps upfront)                                                               6m7y10y                                      78.5                             1.24
                                                                                 6m7y30y                                    126.3                              2.24
 100                    Today                                                    6m10y30y                                   151.9                              2.83
                                                 If rates are
                                                 unchanged at expiry,          * Risk-adjusted RDC is calculated by dividing the RDC by the implied midcurve volatility,
     80                 1m                                                     scaled to a six-month period.
                                                 the trade profits by          Source: Morgan Stanley Research
                        3m                       65bp
     60
                        6m                                                     Offsetting this loss is the PnL from the 6m5y5y. The decline
     40                                                                        in the other two swap rates implies that 5y5y rate will fall by
                                                                               about 19.7bp, as the 10y rate is composed of the 5y and
     20                                                                        5y5y rate. Using current PV01s, the gain on the 6m5y5y
                                                                               would be $865k – offsetting the losses on the vanilla legs.
       0
                                                                               The strike on the 6m5y5y leg is struck at the implied 5y5y
     -20                                                                       level by the two vanilla strikes – thus protecting against
                                                                               potential losses. Astute observers will note that the PV01
     -40
                                                                               weights of the trade may change over time – potentially
           -50 -40 -30 -20 -10             0     10    20      30   40   50
                                                                               creating slippage between the PnL on the vanilla legs and
                                                                               the midcurve. To account for this, the 6m5y5y strike is solved
                                                                               assuming the PV01s move in the worst possible manner
Source: Morgan Stanley Research
                                                                               against the investor, resulting the 6m5y5y strike being
Optimal Selection                                                              roughly 1bp higher.

The 6m5y5y triangle has the best payout ratio profile and
                                                                               SDR Data Update
one of the best vol-adjusted RDC profiles. Exhibit 7 tables
the RDC and vol-adjusted RDC of various triangles, using                       Swaption data continues to flow into the DTCC’s swap data
the implied ATMF midcurve volatility. We eliminate triangles                   repository. Here is this week’s data:
on the 30-year rate, as we believe the 10s/30s curve could
be more volatile than expected 15 .                                            Exhibit 8
                                                                               Weekly SDR Swaption Volume*
Triangle Trades – Limited Downside                                             Notional

The trade is constructed such that the package always has                      $mm               1Y         2Y         3Y       5Y         7Y       10Y       30Y      Total
                                                                               1m             1,926         50         30    3,455      1,726     5,289       396    12,872
positive value – resulting in a maximum loss of the initial
                                                                               3m             3,234        400        892    4,892        732     4,163       506    14,819
premium. If rates are lower at expiry, the investor is long the                6m                 0        110      1,200    3,835        200     2,720       456      8,521
5-year swap rate and short the 10-year swap rate – resulting                   1y               800      1,600        200    1,404        400     2,250       605      7,259
in a short 5-year forward 5-year swap rate (5y5y) position.                    2y               200        800        803         0         0     2,650       115      4,568
                                                                               3y             3,600      1,960          0      400          0     2,129       823      8,912
                                                                               5y               200        400          0      520        125     1,414       100      2,759
To see why, suppose that all legs of the trade are deeply
                                                                               10y                0          0          0         0         0         0       875          875
ITM, and that 5y rates fall by 7bp and 10y rates fall by 13bp                   Total        9,960     5,320     3,125 14,506     3,183 20,615        3,876 60,585
close to expiry. The 6m5y receiver will profit by 7bp running                  *Volumes include USD European swaptions traded between April 12, 2013 and April 16,
                                                                               2013.
on the 5y swap, and the 6m10y receiver will incur losses by                    Source: Morgan Stanley Research, DTCC


15
     See US Interest Rate Strategist: Trouble with the Curve


                                                                                                                                                                       28
                                                                     MORGAN STANLEY RESEARCH

                                                                     May 3, 2013
                                                                     US Interest Rate Strategist




US Agency Mortgage-Backed Securities
Watt Raises Uncertainty
Vipul Jain (212) 761-2647                                             rates backed up by 10 bps and mortgage market saw some
                                                                      real money demand.
Michael Ortiz (212) 761 4212
Emily Zheng (212)-761-1346                                            Exhibit 1
                                                                      FNCL OAS (bps)
    It was a volatile week in the mortgage market. FN2.5 was                           5/2/2013    4/25/2013    Change
     the best performer on the coupon stack, while the belly          2.5                    1.9          5.3       (3.4)
     coupons underperformed due to concerns around the                3.0                    0.7         (0.0)       0.7
                                                                      3.5                    7.8          6.4        1.4
     extension of HARP after Rep. Mel Watt’s nomination as a          4.0                   31.9         29.6        2.3
     FHFA director.                                                   4.5                   55.0         50.6        4.4
                                                                      5.0                   49.7         48.9        0.8
    There is still a lot of uncertainty around the appointment of    5.5                   69.2         69.2        0.0
     Rep. Mel Watt as the FHFA director. Although the market is       6.0                   57.0         58.4       (1.4)
     very focused on the issue of principal forgiveness and            CC Spread              71           72         (1)
                                                                       CC (%)                2.34         2.43     (9.1)
     change in HARP eligibility date, we believe that bigger issue     5Y UST               0.65         0.71       (6.4)
     now is GSE reform and the reshaping the housing market            10Y UST              1.63         1.71       (8.2)
     landscape.                                                        5Y Swap              0.82         0.86       (4.9)
                                                                       10Y Swap             1.81         1.88       (7.3)
    The higher HARP% reported by MBA is surprising to us.             3Mx10Y                 60           61       (0.4)
     Despite our expectation of sustained HARP speed due to            3Yx10Y                 87           87       (0.6)
     higher BofA capacity and MSR transfers, it would still be        Source: Inside Mortgage Finance

     surprising if the absolute number of HARP refinancings go
     up given the smaller outstanding HARP universe. This is          The most noteworthy development this week was nomination
     exactly what MBA survey seems to be indicating.                  of Rep. Mel Watt (D-N.C.) as the FHFA director. Rep. Watt is
    Our views on the MBS market remain unchanged: small
                                                                      a respected and knowledgeable member of the Congress. In
     longs in the basis, down in coupon across the stack, and         the past, he has been a supporter of principal forgiveness
     neutral on GN/FN and 15/30s.                                     and other policy initiatives of the Administration. Market
                                                                      reaction was not favorable as market participants were
                                                                      concerned about a potential change in the HARP eligibility
It was a relatively more volatile week in mortgage market. In         date, and that was one of the reasons that belly coupons
particular, outperformance of FN 2.5s earlier in the week was         underperformed this week.
fairly noteworthy. Due to the outperformance and further rally
in rates, the absolute dollar prices for FN 2.5s hit 101-15+          In our view there are three main questions that investors are
which was within 5 ticks of highs for the year. Higher dollar         contemplating:
prices raised concerns around prepayments, as there was
finally some production in FN 2.5s. FN 2.5s and mortgages             1)    What are the odds that Rep. Mel Watt be confirmed by
more broadly gave up a lot of their gains after the FOMC                    the Senate?
meeting on Wednesday, and underperformance continued
on Thursday due to profit taking on tighter spreads and lower         Our DC watchers assign slightly higher than 50/50 odds that
rates. The FOMC statement was a non-event for the                     he will be confirmed. The process is unlikely to be fast and
mortgage market as market participants did not assign too             easy.
much value to the change in language in the FOMC
statement under which the Fed is willing to both increase and         2)    What will be his key priorities?
decrease the pace of their monthly purchases depending on
the incoming data. Across the coupon stack, only FN 2.5s              On one hand, it can be argued that one of the key reasons
outperformed their Treasury hedges. All the other coupons             that the Administration is looking to replace the current acting
underperformed their hedges with belly coupons                        director is because of his opposition to principal forgiveness.
underperforming the most. FN 3s are still towards the tighter         A CBO study released this week projected that principal
end of the recent range. The better than expected Non Farm            forgiveness would save taxpayers money. So market
Payroll (NFP) report swung us back in the other direction as          participants are assuming that principal forgiveness will be a
                                                                      key priority for the new director. However, as home prices

                                                                                                                                   29
                                                                    MORGAN STANLEY RESEARCH


                                                                    May 3, 2013
                                                                    US Interest Rate Strategist


have started rising and GSEs have returned to profitability,         Exhibit 2
GSE reform and shaping the future of the housing system              MBA Refi Index and HARP %
ought to be much bigger priority, in our view. Also, as home
prices increase, some of the initiatives like principal
forgiveness and the changing HARP cutoff date are likely to           7,000                                                         40%
lose some steam as the potential benefits are diminished.                                                                           35%
                                                                      6,000
3)   Will there be some concessions be made during the                                                                              30%
                                                                      5,000
     confirmation process?
                                                                                                                                    25%
                                                                      4,000
It is well understood that the confirmation process won’t be                                                                        20%
easy. It is possible that the Rep. Watt may have to make              3,000
                                                                                                                                    15%
some concessions to get confirmed for the post. Rep. Mel
                                                                      2,000
Watt’s interview in the Wall Street Journal this morning was                                                                        10%
interesting because he was largely non-committal on a                 1,000                                                         5%
number of key policy issues. During the Senate confirmation
hearing, he is unlikely to have the same luxury. Two years                  0                                                       0%
back, Joseph Smith was nominated for the FHFA director                      Jan 12                 Jul 12             Jan 13
post and he was not confirmed. During the confirmation                       Conventional Refi Index        Aggregate Refi Index   HARP%
hearing, some of the Republication members of the
                                                                     Source: Morgan Stanley Research, MBA
Congress asked pointed questions regarding issues like
principal forgiveness. Based on his responses, the Senate
Republicans argued that he did not have the skills and               There are a couple of themes that in particular raise the odds
experience to be a strong regulator.                                 for higher HARP speeds. Bank of America, which was one of
                                                                     the slower servicers, has been ramping capacity since the
At this point, there is still a fair amount of uncertainty. Among    beginning of last year. Their monthly production has gone up
the various issues that investors are concerned about, we            from $4.7bn in Q1 2012 to $8.7bn in Q1 of 2013. Also, this
don’t expect rollout of principal forgiveness to have much of        year a number of large servicing transfers were finalized.
an impact on the Agency MBS market. However, if the HARP             Exhibit 3 highlights a dramatic change in servicing landscape
eligibility date is changed it would be negative for the belly       over the course of the past 1 year. Specialty finance
coupons. Despite the nomination of Rep. Mel Watt, our base           companies have gained at the expense of large banks. Most
case remains unchanged. We believe the HARP eligibility              of the new servicers are expected to focus on HARP
date will not be changed. However, the odds of it being              refinancings. Also, Quicken has steadily increased their
changed are now higher than they were before. Therefore,             production of HARP refinancings. All these are valid
we would expect the risk premia to be higher for securities          arguments but the MBA refi index is implying that there is a
that are likely to be adversely impacted by a change in the          big increase in HARP refinancing activity based on absolute
HARP eligibility date.                                               loan count basis. This is what we find surprising as the
                                                                     HARP universe has shrunk by 50% over the past year. We
Another prepayments related uncertainty is due to a steady           will see the impact of the recent data from the MBA survey in
increase in HARP percentage even as refinancing index has            a month or two.
risen (Exhibit 2). There are a number of potential technical
issues related to how the HARP percentage is computed.
Even if we discount the absolute level of HARP percentage,
the trend itself is disconcerting.




                                                                                                                                      30
                                                                                       MORGAN STANLEY RESEARCH


                                                                                       May 3, 2013
                                                                                       US Interest Rate Strategist


Exhibit 3
Servicing Portfolios ($bn)
                                        Total Servicing   Market       Change
Servicer                                     1Q13         Share 4Q12-1Q13 1Q12-1Q13
Wells Fargo & Company, IA                    1860          18.8%     -0.7%      1.0%
Bank of America Mtg. & Affiliates, NC        1186          12.0%    -11.0%    -29.8%
Chase, NJ                                    1082          10.9%     -1.8%     -2.2%
Ocwen Financial Corporation, FL               439           4.4%   127.5%     362.1%
Citi, MO                                      435           4.4%     -3.7%    -15.6%
Nationstar Mortgage LLC, TX                   305           3.1%     46.6%    195.3%
US Bank Home Mortgage, MN                     270           2.7%      2.1%     10.8%
Walter Investment Management, FL              213           2.1%   151.6%     147.7%
PHH Mortgage, NJ                              182           1.8%     -1.8%     -1.7%
SunTrust Mortgage Inc., VA                    142           1.4%     -1.8%     -8.1%
PNC Mortgage, OH                              136           1.4%      0.2%     -0.1%
Quicken Loans Inc., MI                        123           1.2%     53.9%    233.2%
BB&T Mortgage, NC                             104           1.1%      2.2%     10.1%
Provident Funding, CA                         101           1.0%     60.6%     75.7%
Source: Inside Mortgage Finance


We maintain our recommended positioning for the mortgage
basis. FN 3 spreads are close to the tighter end of the recent
range. The originations still have not picked up to the degree
that we expected. Although, we like the fundamentals for
agency MBS, we believe that there is a potential for a better
entry point. We continue to recommend a small long in the
basis and down in coupon positioning. We remain neutral on
GN/FN and 15s/30s.




                                                                                                                     31
                                                                                    MORGAN STANLEY RESEARCH

                                                                                    May 3, 2013
                                                                                    US Interest Rate Strategist




Market Data Summary
                  US Treasuries                                   USD Swaps                                           UST Benchmark Swap Spread
     Maturity           YTM (%)      1w Chg (bp)      Maturity            YTM (%)       1w Chg (bp)                 Maturity       Spread (bp)     1w Chg (bp)
         2y               0.202             -2.4           2y              0.332               -1.9                       2y              13.0             0.6
         3y               0.294             -4.2           3y              0.431               -3.0                       3y              13.7             1.2
         5y               0.648             -6.4           5y              0.816               -4.9                       5y              16.7             1.5
         7y               1.073             -5.1           7y              1.276               -6.3                       7y              20.4            -1.2
        10y               1.628             -8.2          10y              1.811               -7.3                      10y              18.2             1.0
        30y               2.827             -8.2          30y              2.767               -7.7                      30y              -6.0             0.5
      2s/3s          (bp)    9.2            -1.8        2s/3s      (bp)     10.0               -1.1                    2s/3s               0.7             0.7
      3s/5s                35.4             -2.2        3s/5s               38.4               -1.9                    3s/5s               3.0             0.3
      5s/7s                42.5              1.3        5s/7s               46.1               -1.5                    5s/7s               3.6            -2.7
     7s/10s                55.5             -3.1       7s/10s               53.4               -0.9                   7s/10s              -2.1             2.2
    10s/30s               119.9              0.1      10s/30s               95.6               -0.4                  10s/30s             -24.2            -0.5
   2s/3s/5s               -13.1              0.2     2s/3s/5s              -14.2                0.4                 2s/3s/5s              -1.1             0.2
  2s/5s/10s               -26.7             -1.0    2s/5s/10s              -25.6               -0.3                2s/5s/10s               1.1             0.7
  5s/7s/10s                 -6.5             2.2    5s/7s/10s                -3.7              -0.3                5s/7s/10s               2.9            -2.5
 5s/10s/30s               -10.9             -1.0   5s/10s/30s                 1.9              -1.0               5s/10s/30s              12.9             0.0

                  US Agencies                          Mortgage Pass-Through OAS                                           Ginnie/Fannie Swaps

                       Spread to                      Coupon        LIBOR OAS           1w Chg (bp)                    Swap     Spread (32nds)         1w Chg
     Maturity          UST (bp)      1w Chg (bp)    FNMA 3.5                  -45                -5               GN/FN 3.5             2-09+          -0-010
   2y FNMA                 -10.0             1.9    FNMA 4.0                  -31                -3               GN/FN 4.0             2-120          -0-056
  2y FHLMC                   1.0             0.0    FNMA 4.5                  -16                 1               GN/FN 4.5             1-080          -0-01+
   3y FNMA                   6.3            -0.5    FNMA 5.0                   44                 2               GN/FN 5.0             0-29+          -0-020
  3y FHLMC                   7.5             0.0
                                                     Mortgage Performance vs. Swaps                                        Gold/Fannie Swaps
    3y FHLB                 -3.5             2.0
   5y FNMA                  17.0             1.0      Coupon                Price           1w Perf                    Swap     Spread (32nds)         1w Chg
  5y FHLMC                  11.8             0.8    FNMA 3.5           106-156               0-042                FG/FN 3.5             -0-080          0-000
    5y FHLB                  2.0             0.0    FNMA 4.0           106-302               0-006                FG/FN 4.0             -0-080          0-01+
  7y FHLMC                  23.0            -0.5    FNMA 4.5           107-20+              -0-02+                FG/FN 4.5             -0-250          0-000
 10y FHLMC                   4.0             0.8    FNMA 5.0           108-03+              -0-012                FG/FN 5.0             -0-300          0-000

             Forward Swap Rates                          Swaption Implied Volatility                                      US TIPS - Real Yields

  Maturity              Rate (%)     1w Chg (bp)      Maturity    Norm Vol (bp)         1w Chg (bp)                 Maturity     Real Yield (%)    1w Chg (bp)
     1y x 1y                0.38           -2.70     3m x 2y                 18.3              -0.2                  TII4/15           -1.25%            13.6
     1y x 2y                0.50           -3.96     3m x 5y                 41.8               0.4                  TII4/18           -1.37%             7.1
     2y x 2y                0.86           -6.14    3m x 10y                 60.5              -0.4                  TII1/23           -0.65%             4.8
     2y x 5y                1.67           -8.24     6m x 2y                 22.0              -0.5                  TII2/43            0.44%             0.8
     3y x 2y                1.41           -7.47     6m x 5y                 48.7              -0.1
                                                                                                                      US TIPS - Breakeven Inflation
     3y x 5y                2.14           -9.07    6m x 10y                 65.9              -0.9
    3y x 10y                2.78           -9.35     1y x 10y                73.2              -0.6                 Maturity          BEI (bp)     1w Chg (bp)
     4y x 5y                2.57          -10.02      2y x 5y                73.9               0.1                  TII4/15           145.99            -16.1
     5y x 5y                2.91          -10.49     3y x 10y                86.5              -0.6                  TII4/18           199.85            -13.4
    5y x 10y                3.27          -10.15      5y x 5y                95.2              -0.4                  TII1/23           214.50            -12.8
   10y x 10y                3.63           -9.56     5y x 10y                91.8              -0.5                  TII2/43           238.36             -9.0
   10y x 20y                3.53           -9.12    10y x 10y                88.6               0.3

             Treasury GCF Futures                                 Fed Monitor                                                  Other Market Data

  Contract              Rate (%)     1w Chg (bp)   Meetings      Expected Rate (%)     1w Chg (bp)            Index/Security             Close         1w Chg
 GCF Jun13                0.120              0.0       Target              0.125                                   MS FCI               -0.32           -0.02
  GCF Jul13               0.120              0.5    4/30/2014               0.11               -1.0               S&P 500            1,597.59           12.43
 GCF Aug13                0.115             -0.5    6/18/2014               0.12               -0.7          DJ Industrials         14,831.58          130.78
 GCF Sep13                0.120              0.0    7/30/2014               0.12               -0.5              USD/JPY               97.950          -1.300
 GCF Oct13                0.120             -0.5    9/17/2014               0.12               -0.5             USD/EUR                 1.306           0.005
 GCF Nov13                0.120             -1.0   10/29/2014               0.13               -0.5              10y Bund              1.16%            -8.05
                                                   12/17/2014               0.14               -0.8               10y JGB              0.56%            -2.49
                Eurodollar Futures
                                                    1/28/2015               0.15               -0.5                10y Gilt            1.66%            -6.15
        Pack            Rate (%)     1w Chg (bp)    3/18/2015               0.17               -1.3                   Gold            1467.40            9.10
     Whites                 0.30            -1.4    4/29/2015               0.19               -1.0               Gasoline             278.06           -3.00
       Reds                 0.40            -3.4    6/17/2015               0.22               -0.2          3m Libor -OIS              15.11            0.55
     Greens                 0.67            -6.5     8/5/2015               0.24               -1.0            CDX NA IG                74.09           -4.83
      Blues                 1.19            -8.4    9/23/2015               0.28               -0.2                    VIX              13.59             0.0

Source: Morgan Stanley Research
All levels as of close: 02-May-13




                                                                                                                                                                 32
                                                                                                                        MORGAN STANLEY RESEARCH


                                                                                                                        May 3, 2013
                                                                                                                        US Interest Rate Strategist



Current Trade Ideas
                                                                                                                                                                    Levels
                                                                                                                                                                                 Re-                 Current
                 Trade                                                    Rationale                                     Entry Date Close Date   Entry    Current   Objective              Units
                                                                                                                                                                               assess                 chg


Treasuries


                                          We look for duration neutral RD&C trades with a protection against tail
Long 5s/10s/30s 60:62 Fly                                                                                                1/10/2013     -        -98.10   -103.90    -110.00    -80.00   bp running    7.20
                                          risks



                                          We look for duration neutral RD&C trades with an upside from the risk of
Short 10s/15s/30s PCA Fly                                                                                                4/25/2013     -        -46.30    -42.50    -40.00     -58.00   bp running    3.70
                                          increased Fed purchases being priced in.



                                          We target optimal rolldown points using a structure to replicate 5y1y
Long 6y, Short 5y Bond                                                                                                   5/2/2013      -        38.40     38.40      32.00      42.00   bp running    0.00
                                          forward rate exposure.



                                          As the soft patch in economic data gets closer to bottoming out, we re-
7s/30s Steepener (1:1)                                                                                                   5/2/2013      -        179.30   179.30     190.00     174.00   bp running    0.00
                                          initiate our curve steepening trade.


                                          This trade has a positive carry of 1.5bp for 3 months. If the soft patch in
2s/3s Tsy Curve Flattener                 the second quarter persists we can expect 2s/3s to flatten from current        5/2/2013      -        11.40     11.40      9.00       14.00   bp running    0.00
                                          level of 11bp.



TIPS


Short 5y25y Breakeven                     We expect flatter forward breakeven curves moving forward                     12/14/2012     -        260.00   248.00     245.00     265.00   bp running    12.00




10yr BEI vs 10s/30s UST                   Relative value trade                                                           4/26/2013     -        58.00     51.00      82.00      48.00   bp running    7.00




Swaptions

Buy 100 6m5y 1% ATMF and 6m5y5y
                                                                                                                                                                                          bp of
2.66% rcvrs, sell 6m10y 1.77% rcvrs, Limited downside trade with high RDC, optimal by metrics                            5/1/2013      -        29.00     29.00      60.00      15.00                 0.00
                                                                                                                                                                                         notional
pay 29bp


Buy 2y5y rcvr @1.23, sell 2y1y @
                                          This trade has a high level of RDC, and is protected against a sell off.       12/6/2012     -         0.00     -1.50      20.00     -10.00   bp running    -1.50
0.56, costless


Long 10y tails on the 1y 5s/10s/30s
                                          This trade is a cheap hedge on lower rates, as the 10y leg is well
receiver fly, with 10y tail struck 6 bp                                                                                  1/18/2013     -         0.00     -0.30      15.00     -15.00   bp running    -0.30
                                          correlated to it.
OTM for zero cost


6m 1s/2s OTM bear steepener, 20 bp
                                   The trade carries flat, and hedges a significant acceleration of Fed hikes            3/14/2013     -         0.00     -0.20      10.00      -5.00   bp running    -0.20
OTM on 1s and 23 bp OTM 2s


Buy 100mm 1y10y ATMF, sell                This trade earns high levels of RDC, and only loses if 10y20y rates fall                                                                        bp of
                                                                                                                         4/4/2013      -         0.00     -15.50     50.00     -25.00                -15.50
100mm 1y30y 39bp OTM receivers            past historic lows.                                                                                                                            notional


Sell 228mm 3m10y atmf straddles,
                                          Profits in higher 10s/30s curve vol due to QEi volatility, attractive on RV
buy 100mm 7bp wide 3m30y                                                                                                 4/18/2013     -         0.00     0.20       10.00      -5.00   bp running    0.20
                                          and vs. curve options market
strangles



Swaps

                                          Long-dated forward rates keep extending to higher levels. This move is in
Short 20s on 10s/20s/30s Swap             spite of the fact that the 10y Treasury keeps getting hung-up near 1.85%.
                                                                                                                         1/17/2013     -        28.50     29.30      31.00      25.00   bp running    0.80
Butterfly (.5/1/.5)                       We recommend this trade for investors that wish to gain exposure to the
                                          further increase in these forwards

                                          This trade has a high 3 month rolldown and carry of 3bps and a 1-year
Long 7s on 3s/7s/10s Swap Fly             trading range of only 11bps. Unless we see a large selloff in rates, the       4/11/2013     -        17.60     15.50      15.00      19.00   bp running    2.10
                                          trade is likely to profit.




                                                                                                                                                                                                          33
                                                                                                     MORGAN STANLEY RESEARCH


                                                                                                     May 3, 2013
                                                                                                     US Interest Rate Strategist


                                                                                                                                                 Levels
                                                                                                                                                              Re-                  Current
               Trade                                      Rationale                                  Entry Date Close Date   Entry    Current   Objective              Units
                                                                                                                                                            assess                  chg


Mortgages


                            Golds are trading at a relatively cheap level and we expect real money
Long GD/FN 3                                                                                          2/28/2013      -       -15.00    -13.50     -10.00     -17.00     ticks        1.50
                            demand to pick up at these levels.



                            We recommend an overweight for lower coupons compared to higher
Long FN 3.0s                                                                                          10/19/2012     -        -6.00     1.00      -10.00     10.00    bp running     -7.00
                            coupons.



Note: The portfolio represents hypothetical, not actual, investments. Profit and loss does not include expenses such as commissions and fees. Past
performance is no guarantee of future results.

Please see US Interest Rate Strategy - Historical Trade Table (May 3, 2013) for a 1-year history of our trades.




                                                                                                                                                                                        34
                                                                        MORGAN STANLEY RESEARCH

                                                                        May 3, 2013
                                                                        US Interest Rate Strategist




US Interest Rate Strategy Team
US Government Bonds
           Matthew Hornbach      Head of US Interest Rate Strategy        matthew.hornbach@morganstanley.com   +1 (212) 761-1837
           Guneet Dhingra        US Treasury Strategist                   guneet.dhingra@morganstanley.com     +1 (212) 761-1445


Treasury Inflation Protected Securities
           Tiffany Wilding       US Inflation Strategist                  tiffany.wilding@morganstanley.com    +1 (212) 761-4415


Interest Rate Derivatives
           Ankur Shah            Interest Rate Derivatives Strategist     ankur.h.shah@morganstanley.com       +1 (212) 761-1909
           Mikhail Levin         Interest Rate Derivatives Strategist     mikhail.levin@morganstanley.com      +1 (212) 761-8556


Short Duration Strategy
           Subadra Rajappa       Short Duration Strategist                subadra.rajappa@morganstanley.com    +1 (212) 761-2983


Agency Mortgage-Backed Securities
           Vipul Jain            Head of US Agency MBS Strategy           vipul.jain2@morganstanley.com        +1 (212) 761-2647

           Michael Ortiz         Agency MBS Strategist                    michael.ortiz@morganstanley.com      +1 (212) 761-4212
           Emily Zheng           Agency MBS Strategist                    emily.zheng@morganstanley.com        +1 (212) 761-1346




                                                                                                                              35
                                                                                MORGAN STANLEY RESEARCH

                                                                                May 3, 2013
                                                                                US Interest Rate Strategist




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                                                                                                                                                    36
                                                                                           MORGAN STANLEY RESEARCH

                                                                                           May 3, 2013
                                                                                           US Interest Rate Strategist




                             Coverage Universe    Investment Banking Clients (IBC)
                                            % of                   % of % of Rating
    Stock Rating Category       Count       Total     Count Total IBC Category
Overweight/Buy                   1034          36%          399          39%           39%
Equal-weight/Hold                1250          44%          479          47%           38%
Not-Rated/Hold                    105           4%           27           3%           26%
Underweight/Sell                  473          17%          123          12%           26%
Total                           2,862                      1028
Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual
circumstances (such as the investor's existing holdings) and other considerations. Investment Banking Clients are companies from whom Morgan
Stanley received investment banking compensation in the last 12 months.
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                                                                                                                                                                         37
                                                                                            MORGAN STANLEY RESEARCH

                                                                                            May 3, 2013
                                                                                            US Interest Rate Strategist




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5-3-13 po




                                                                                                                                                                          38
                                                         MORGAN STANLEY RESEARCH




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