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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 email@example.com +1 (212) 761-1837 Guneet Dhingra US Treasury Strategist firstname.lastname@example.org +1 (212) 761-1445 Treasury Inflation Protected Securities Tiffany Wilding US Inflation Strategist email@example.com +1 (212) 761-4415 Interest Rate Derivatives Ankur Shah Interest Rate Derivatives Strategist firstname.lastname@example.org +1 (212) 761-1909 Mikhail Levin Interest Rate Derivatives Strategist email@example.com +1 (212) 761-8556 Short Duration Strategy Subadra Rajappa Short Duration Strategist firstname.lastname@example.org +1 (212) 761-2983 Agency Mortgage-Backed Securities Vipul Jain Head of US Agency MBS Strategy email@example.com +1 (212) 761-2647 Michael Ortiz Agency MBS Strategist firstname.lastname@example.org +1 (212) 761-4212 Emily Zheng Agency MBS Strategist email@example.com +1 (212) 761-1346 35 MORGAN STANLEY RESEARCH May 3, 2013 US Interest Rate Strategist Disclosure Section The information and opinions in Morgan Stanley Research were prepared by Morgan Stanley & Co. 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Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold and sell. Investors should carefully read the definitions of all ratings used in Morgan Stanley Research. In addition, since Morgan Stanley Research contains more complete information concerning the analyst's views, investors should carefully read Morgan Stanley Research, in its entirety, and not infer the contents from the rating alone. In any case, ratings (or research) should not be used or relied upon as investment advice. 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. Global Stock Ratings Distribution (as of April 30, 2013) For disclosure purposes only (in accordance with NASD and NYSE requirements), we include the category headings of Buy, Hold, and Sell alongside our ratings of Overweight, Equal-weight, Not-Rated and Underweight. Morgan Stanley does not assign ratings of Buy, Hold or Sell to the stocks we cover. Overweight, Equal-weight, Not-Rated and Underweight are not the equivalent of buy, hold, and sell but represent recommended relative weightings (see definitions below). To satisfy regulatory requirements, we correspond Overweight, our most positive stock rating, with a buy recommendation; we correspond Equal-weight and Not-Rated to hold and Underweight to sell recommendations, respectively. 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. 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