Morgan stanley -Tick Tock Taper

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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 31, 2013                                                                                   Tiffany Wilding

                                                                                                         Guneet Dhingra, CFA
North     US Interest Rate Strategist                                                                    Ankur Shah
America
          Tick Tock Taper                                                                                Mikhail Levin

          We believe the market is priced for tapering to begin                                          Emily Zheng
          in September 2013. Our view is that December is a
                                                                           Regular Features
          more likely time for tapering to begin. While this might
          suggest a bullish stance toward duration, we remain                   Our Views
          tactically neutral. We also turn neutral on the yield                 In Case You Missed It
          curve and stop-out of our 7s/30s and 10s/30s curve                    Event Calendar
          steepeners. If the market prices a June/July tapering,                Government Bond Supply
          we will consider moving overweight duration and                       Treasury Yield Forecasts
          reentering our curve steepeners.
                                                                                Market Data Summary
          US Governments                                                        Trade Ideas
          This past week’s spike in implied and realized volatility has
          brought our attention to the pricing of convexity in             Global Strategists
          Treasuries. Higher volatility can work against a 10s/30s              Spring Global Strategy Outlook
          steepener position via higher convexity being priced-in in            European Interest Rate Strategist
          the back end. We move neutral on the 10s/30s curve.                   Japan Interest Rate Strategist
                                                                                The Inflation Strategist
          US Treasury Inflation-Protected Securities
          Although we believe breakeven valuations are ‘fair’, we               Agency MBS Weekly
          can’t ignore the reallocation flows out of the asset class.                                 Lower/Flatter           Higher/Steeper
          Hence, we like tactically entering short 10-year breakeven                                    Tighter                    Wider

          and 5s/30s breakeven steepener trades                                                             –                        +
                                                                           US Treasury Yields
          US Short Duration Strategy                                       US Treasury Curve
          Overnight repo rates fell precipitously averaging in the low     US TIPS Breakevens
          single digits this week. The SEC is expected to vote on          US TIPS BEI Curve
          MMF reform proposals next Wednesday. We outline a                USD Swap Spreads
          potential timeline for MMF reform.                               USD Swap Spread Curve
                                                                           USD Swaption Gamma
          US Interest Rate Derivatives: Swaps                              USD Swaption Vega
          Mortgage hedging has driven spreads significantly wider in       US Agency MBS Basis
          the front-end and belly of the curve. We expect continued        US Agency MBS Up-In-Coupon
          widening pressure on belly spreads from mortgage                 US Agency MBS GN/FN
          hedging, along with pressure on back-end spreads from            US Agency MBS 15/30
          the June 10 start of mandatory clearing.                                                                Prior       Current
          Special Topic: The Revival of Volatility
          The spike in rates has driven vols higher, reversing the          Due to the nature of the fixed income market, the issuers or
          divergence between vol and term premium. We                       bonds of the issuers recommended or discussed in this report
          highlighted the risk to higher vol if 10-year swap rates          may not be continuously followed. Accordingly, investors must
          crossed 2.2%, and expect richer implied vol to persist from       regard this report as providing stand-alone analysis and should
          revived convexity hedging.                                        not expect continuing analysis or additional reports relating to
                                                                            such issuers or bonds of the issuers.
          US Interest Rate Derivatives: Volatility
          Vol richened as real money hedging and tapering talk kept         Morgan Stanley does and seeks to do business with
          intermediate tails bid relative to the upper left and right.      companies covered in Morgan Stanley Research. As
                                                                            a result, investors should be aware that the firm may
          We recommend 1y1y30y FVA as a positive carry, long
                                                                            have a conflict of interest that could affect the
          vega trade with an attractive historical entry point.             objectivity of Morgan Stanley Research. Investors
          US Agency Mortgage-Backed Securities                              should consider Morgan Stanley Research as only a
          Mortgage basis carry has worsened and realized volatility         single factor in making their investment decision.
          is highly elevated. Also, there is very high event risk in the    For analyst certification and other important
          near term. We continue to recommend a neutral stance              disclosures, refer to the Disclosure Section,
          regarding the mortgage basis and across the stack.                located at the end of this report.
                                                                               MORGAN STANLEY RESEARCH

                                                                               May 31, 2013
                                                                               US Interest Rate Strategist




Our Views
                                        Our Views                                                                Suggested Strategies
US Treasuries
    We believe the market is priced for tapering to begin in September 2013. Our view is
     that December is a more likely time for tapering to begin. While this might suggest a
     bullish stance toward duration, we remain tactically neutral. We also turn neutral on
     the yield curve and stop-out of our 7s/30s and 10s/30s curve steepeners.
    Because we think a June tapering is off-the-table (not enough labor market data
     between now and then), and a July tapering is unlikely (not a meeting when the
     FOMC updates their Summary of Economic Projections), we would prefer to go long                  Neutral outright duration
     duration if/when the market prices a high likelihood of tapering at those meetings.
                                                                                                      Neutral on yield curve shape
    Given the risks to higher yields in the near-term driven by better-than-expected
                                                                                                      Long 10s on 5s/10s/30s PCA Fly (DV01 weights:
     economic data, and our constructive view on implied volatility, we relent on our 7s/30s
                                                                                                       0.60/1.0/0.62)
     and 10s/30s yield curve steepeners. We suggest investors cut losses. We did not
     appropriately measure the risk-reward of the trade, and turn neutral on curve shape              Short 15s on 10s/15s/30s PCA Fly (DV01
     until we find our bearings again. When we feel the time is right to move overweight               weights: 0.56/1.0/0.53
     duration, we will likely express that view by suggesting an overweight to intermediate
     maturity Treasuries relative to the wings (e.g., 2s/7s/30s or 2s/5s/10s butterflies)
     instead of 7s/30s or 10s/30s curve steepeners.
    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        Tactically short 10y breakeven
     risk premium, while the 2.5% projected PCE inflation parameter will ultimately cap the
                                                                                                      Tactically long 5s/30s breakeven steepeners
     extent to which intermediate inflation risk premiums can rise. We see intermediate
     forwards being capped at 2.8% to 3.0%.                                                           10s/30s real curve steepener
    We forecast spot breakevens to move sideways to slightly lower in 2013, as a                     Overweight the 15- to 20-year sector of real yield
     moderation in headline CPI inflation puts pressure on spot breakeven spreads.                     curve
    Amid a continued end-user reallocation we see scope for breakeven weakness. We                   Long TIPS ASW vs. Nominal ASW
     like being short 10y breakevens and 5s/30s breakeven steepeners on a tactical basis.
US Interest Rate Derivatives: Swaps
                                                                                                      Biased toward wider spreads in the belly and on
    We continue to fundamentally like wideners. Recent mortgage hedging activity has                  the long-end
     widened spreads in the belly of the curve, and will continue to bias spreads wider.
                                                                                                      Short 20s on 10s/20s/30s swaps fly weighted
    The upcoming June 10 Category 2 clearing mandate may lead to wider spreads on                     50/50
     the back-end. While we do not envision a market disruption as likely, the additional
                                                                                                      Long 7s on 3s/7s/10s swaps fly weighted 50/50
     costs of swap trading may cause investors to seek out other sources of duration.
                                                                                                      Long ED12 on ED4/ED12/ED20 Eurodollar Fly
US Interest Rate Derivatives: Vol
                                                                                                      2y 1s/5s bull flatteners
    We are bullish on gamma again. The opening of tapering has caused vol to richen                  Notional-neutral 1y 10y/30s bull steepeners
     against term premium, reverting closer to fair value. We expect mortgage convexity to
                                                                                                      Buy 30y gamma against 10y gamma
     fuel the push higher.
                                                                                                      6m 1s/2s OTM bear steepeners
    We like long-term rolldown and carry trades. We also believe 30-year gamma is
     cheap to 10-year gamma, as QE∞ uncertainty may spur moves in the 10s/30s curve.                  6m5y5y triangles
                                                                                                      3m3y 1x2x1 receiver flies
US Agency Mortgage-Backed Securities


    Overall, the risk reward tradeoff is not very favorable to owning mortgages despite
     more attractive valuations. The carry is much lower and realized volatility is highly            Overweight the GD/FN 3 swaps
     elevated. And there is very high event risk in the near term.




                                                                                                                                                     2
                                                                                  MORGAN STANLEY RESEARCH

                                                                                  May 31, 2013
                                                                                  US Interest Rate Strategist




In Case You Missed It
                                    Key Themes                                                                     Detailed Coverage
Pressing the Hard Ways                                                                       May 17, 2013
                                                                                                 Pressing the Steepener
   We press our 7s/30s and 10s/30s curve steepeners by suggesting investors                     Setting Up for the 2-, 5- and 7-Year Auctions
    maintain or add exposure. While these curves have steepened since our                        Focus on the Real Rate
    recommendation on May 3, we believe these steepeners continue to offer an                    Prime Target
    attractive way of being short the market while offering positive carry and                   Regulation and Rolldown
    rolldown.
                                                                                                 Mind the Gap
                                                                                                 Looking for Someone to Step In
Brave New World                                                                              May 10, 2013
                                                                                                 A Brave New Way to Make Money with Forward Rates
   The current interest rate market may feel more like dystopia than utopia for                 Positioning for the June-September Futures Rolls
    bond market investors. The irony of the lower-for-longer Brave New World is
                                                                                                 Tactically Short 5y5y Breakevens
    that as the ability to extract value from the market worsens, the ability to find
    value improves. We present a new framework to help investors find – and                      Never Enough
    extract – value from the yield curve.                                                        Retuning HARP Cutoff
                                                                                                 Download Report
High Enough?                                                                                 May 3, 2013
                                                                                                 Targeting Optimal Rolldown in Treasuries
                                                                                                 Inflation Insurance – Worthless?
   We suggest investors enter 7s/30s and 10s/30s yield curve steepeners. While                  Opportunities in the Front-end
    the 7s/30s and 10s/30s curves have been trading more directionally since
                                                                                                 Treasury Issuance and Spreads
    QE∞ was announced, these steepeners get you slightly short duration and
    with positive carry and rolldown – the holy grail of bond market investing.                  Gamma: The Price Is Right
                                                                                                 Watt Raises Uncertainty
                                                                                                 Download Report
Comfortably Numb                                                                             April 26, 2013
                                                                                                 Free Falling
   We remain tactically neutral on duration and curve shape. While economic                     Short 15s on the 10s/15s/30s PCA Butterfly
    data seem poised to continue underperforming consensus expectations, we                      Carving up the Curves
    are at the lower bound of our expected range for yields this quarter with                    Supply Matters
    market sentiment very balanced. With the FOMC meeting and the nonfarm                        Trading the Expiry Curve
    payroll report coming up, our 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                   Breakevens – A Perfect Storm
    suggest that risks are skewed to a flatter 10s/30s curve if market expectations
                                                                                                 Banking on Domestic Deposits
    of tapering move 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                     Accounting for Curve Risks
    long end curve steepeners strategically. We are neutral on swap spreads                      Trading Around Wider Spreads
    tactically, and on implied volatility strategically. The largest risk to our strategic
                                                                                                 Hedging the Steepener
    views is an economic soft patch that goes beyond our expectations and
    significantly beyond market expectations – calling into question second half                 Support Stays Strong
    growth prospects.                                                                            Download Report




                                                                                                                                                     3
                                                                                                     MORGAN STANLEY RESEARCH

                                                                                                     May 31, 2013
                                                                                                     US Interest Rate Strategist




Event Calendar
              Monday                                 Tuesday                               Wednesday                                Thursday                                 Friday

                3-Jun                                  4-Jun                                   5-Jun                                  6-Jun                                   7-Jun

US: ISM Manufacturing                   US: Trade Balance                      US: ADP Survey                          US: Jobless Claims                     US: NFP
US: Construction Spending               US: Fed’s George, Fisher               US: ISM Nonmanufacturing                US: Fed’s Plosser speak                US: Consumer Credit
US: Fed’s Williams speaks               speak                                  US: Factory Orders                      EUR: ECB Rate Decision
UK: PMI Manufacturing                                                          US: Beige Book                          EUR: Draghi Press
                                                                               EUR: GDP                                Conference
                                                                                                                       UK: BoE Rate Decision




               10-Jun                                 11-Jun                                  12-Jun                                 13-Jun                                  14-Jun

US: Category 2 Swap                     US: Wholesale Trade                                                            US: Jobless Claims                     US: PPI
Clearing Deadline                       JP: BoJ Rate Decision                                                          US: Retail Sales                       US: Current Account Balance
                                                                                                                       US: Import Price Index                 US: Industrial Production
                                                                                                                                                              US: U. Michigan Consumer
                                                                                                                                                              Sentiment

Source: Morgan Stanley Research, Bloomberg




Government Bond Supply
               03-Jun                                   04-Jun                                 05-Jun                                  06-Jun                                   07-Jun

US: 3m T-Bill $30bn, 6m T-Bill         US: 1m T-Bill $45bn*                       GER: OBL 0.25% April 2018           US: 3y, 10y, 30y Announcement
$25bn                                  AUT: RAGB Auction, €1.43bn                 Tap, €4bn                           US: 3m, 6m T-Bill Announcement
US: 1m T-Bill Announcement             RAGB 1.75% October 2023 and                SWE: SGB Auction                    FRA: OAT Auction, €7-8bn
                                       RAGB 4.3% September 2017                   Announcement                        OAT 3.5% April 2020, OAT 1.75%
                                       UK: UKTi 0.125% March 2024,                CAN: 30y Linker Auction, CAD        May 2023 and OAT 2.75% October
                                       £1.6bn                                     0.7bn                               2027
                                       JPY: 10y JGB, ¥2400bn                                                          SPA: Bono Auction, €4bn*
                                                                                                                      SPGB 2.75% March 2015, SPGB
                                                                                                                      3.3% July 2016 and SPGB 4.4%
                                                                                                                      October 2023
                                                                                                                      NOR: NGB Announcement
                                                                                                                      JPY: 30y JGB, ¥600bn
                                                                                                                      CAN: 2y Nominal Announcement


               10-Jun                                   11-Jun                                 12-Jun                                  13-Jun                                   14-Jun

US: 3m T-Bill $30bn*, 6m T-Bill        US: New 3-Year UST, $32bn*                 US: 10-Year Reopening,              US: 30-Year Reopening, $13bn*              BEL: Optional Reverse Inquiry
$25bn*                                 US: 1m T-Bill $45bn*                       $21bn*                              US: 30-Year TIPS Announcement              Option, €0-0.5bn*
US: 1m T-Bill Announcement             NETH: DSL April 2016 Tap, €2.5-            GER: BKO 0% June 2015,              US: 3m, 6m T-Bill Announcement             JPY: 5y JGB, ¥2700bn*
ITA: BTP Announcement                  3.5bn                                      €5bn                                ITA: BTP Auction, €6bn*
                                       UK: New UKT September 2023,                SWE: SGB Auction, SEK               UK: UKT 4.25% June 2032, £2bn*
                                       £3.5bn*                                    3.5bn
                                       NOR: NGB Auction, NOK3bn*                  JPY: Auction for Enhanced
                                       DEN: DGB Auction, DKK 3bn*                 Liquidity, ¥300bn*
                                                                                  CAN: 2y Nominal Auction,
                                                                                  CAD 3.3bn*

Source: National Treasuries, Federal Reserve, Morgan Stanley Research
Note: * = Size Estimated; ** Syndication/Mini Tender will happen in the week commencing; *** = Auction not announced yet ; T: Treasury Purchase, TII: TIPS Purchase, S: Treasury Sales




                                                                                                                                                                                         4
                                                                                          MORGAN STANLEY RESEARCH

                                                                                          May 31, 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                0.289         0.308            0.313            -0.5
1Q14            -            0.58       0.80         1.29    1.81    2.46   3.63               3-Year                0.495         0.465            0.525            -6.1
                                                                                               5-Year                0.987         0.904            1.020           -11.6
                                                                                               7-Year                1.478         1.390            1.512           -12.2
                                       Bull Case
                                                                                               10-Year               2.117         2.032            2.146           -11.4
Quarter      Hike Exp          2y            3y        5y      7y     10y    30y               30-Year               3.252         3.195            3.265            -7.0
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                 0.206         0.156            0.212            -5.6
3Q13           +3m           0.15       0.25         0.40    0.76    1.38   2.53               2s/5s                 0.698         0.595            0.706           -11.1
4Q13           +3m           0.15       0.25         0.40    0.77    1.43   2.57               2s/7s                 1.189         1.082            1.198           -11.7
1Q14           +3m           0.15       0.25         0.40    0.76    1.37   2.51               2s/10s                1.827         1.723            1.833           -11.0
                                                                                               2s/30s                2.963         2.886            2.952            -6.5
                                                                                               3s/5s                 0.492         0.439            0.495            -5.6
                                       Bear Case
                                                                                               3s/7s                 0.983         0.926            0.987            -6.1
Quarter      Hike Exp          2y            3y        5y      7y     10y    30y               3s/10s                1.622         1.567            1.621            -5.4
1Q13          -1.5m          0.34       0.50         0.93    1.40    2.04   3.19               5s/7s                 0.491         0.487            0.492            -0.5
2Q13             -           0.50       0.69         1.16    1.65    2.29   3.45               5s/10s                1.129         1.128            1.126             0.2
3Q13             -           0.66       0.88         1.38    1.88    2.53   3.69               5s/30s                2.265         2.291            2.245             4.6
4Q13             -           0.81       1.07         1.59    2.10    2.79   3.94               7s/10s                0.639         0.641            0.634             0.7
1Q14             -           0.97       1.24         1.78    2.30    2.94   4.09               7s/30s                1.774         1.805            1.753             5.1
                                                                                               10s/30s               1.135         1.163            1.119             4.4
                                                                                               Butterfly
                              Base Case Risk Channel
                                                                                               2s/3s/5s              -0.286       -0.283        -0.283                0.0
Quarter      Hike Exp          2y            3y        5y      7y     10y    30y               2s/5s/7s               0.207        0.108         0.214              -10.6
Current         -            0.15       0.25         0.62    1.09    1.72   2.88               2s/5s/10s             -0.431       -0.533        -0.420              -11.3
Current         -            0.36       0.53         0.97    1.46    2.09   3.25               2s/5s/30s             -1.567       -1.696        -1.539              -15.7
1Q13            -            0.15       0.25         0.59    1.05    1.68   2.83               2s/7s/10s              0.550        0.440         0.564              -12.4
1Q13            -            0.34       0.50         0.93    1.40    2.04   3.19               2s/7s/30s             -0.586       -0.723        -0.555              -16.8
2Q13           +3m           0.15       0.25         0.63    1.11    1.74   2.90               2s/10s/30s             0.692        0.560         0.714              -15.4
2Q13           +3m           0.37       0.54         0.99    1.48    2.12   3.28               3s/5s/7s               0.002       -0.048         0.002               -5.0
3Q13           +3m           0.23       0.37         0.79    1.28    1.92   3.09               3s/5s/10s             -0.637       -0.689        -0.632               -5.7
3Q13           +3m           0.40       0.57         1.04    1.53    2.18   3.35               3s/10s/30s             0.486        0.404         0.502               -9.8
4Q13           +1m           0.37       0.54         1.00    1.50    2.19   3.36               5s/7s/10s             -0.148       -0.155        -0.142               -1.2
4Q13           +1m           0.50       0.70         1.19    1.69    2.39   3.56               5s/7s/30s             -1.284       -1.318        -1.261               -5.7
                                                                                               5s/10s/30s            -0.006       -0.035         0.007               -4.3
                                                                                               7s/10s/30s            -0.497       -0.522        -0.485               -3.7
      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: 31, May 2013
For more information on our rate forecast methodology please consult US Interest Rate Strategist: Unconventional Uncertainty.


                                                                                                                                                                            5
                                                                          MORGAN STANLEY RESEARCH


                                                                          May 31, 2013
                                                                          US Interest Rate Strategist



US Interest Rates
Is Tapering Tightening?
Matthew Hornbach (212) 761-1837                                           had priced before the Chairman’s testimony. However, this
                                                                          seems at odds with the Chairman’s characterization of
Tiffany Wilding (212) 761-4415
                                                                          tapering. In particular, the Chairman stated that tapering does
Ankur Shah (212) 761-1909                                                 not constitute a tightening of policy, but rather easing at a
Guneet Dhingra (212) 761-1445                                             slower rate.

                                                                          Exhibit 1
     The simple interpretation of the recent rise in interest rates is
      that the market is pricing tighter monetary policy relative to      Fed Funds Futures Strip
      what it had priced before Chairman Bernanke’s testimony.
                                                                            %
      But this interpretation is inconsistent with the Chairman’s own
      suggestion that tapering is not a tightening, but rather easing      0.75
      at a reduced rate.
     We attempt to resolve the inconsistency by looking at the
      behavior of the Morgan Stanley Financial Conditions Index
      (MSFCI). Based on our metric, financial conditions have              0.50
      actually eased since the Chairman’s comments.

     Why are financial conditions easier if the bond market
      interprets an earlier tapering as tighter monetary policy? The
      answer lies in the market’s expectations for growth                  0.25
      sustainability. We draw from a simple equity pricing model
      that suggests if growth expectations are increasing faster                                                           1st Rate Hike
      than rates, equity prices should remain stable or rise –                                                             in 1H15
      helping ease financial conditions.                                   0.00
     We believe the market is priced for tapering to begin in                May 13 Oct 13 Mar 14 Aug 14 Jan 15                    Jun 15
      September 2013. Our view is that December is a more likely                      Expected Funds Rate             Fed Funds Futures Strip
      time for tapering to begin. While this might suggest a bullish
      stance toward duration, we remain tactically neutral. We also       Source: Morgan Stanley Research, CBOT-CME
      turn neutral on the yield curve and stop-out of our 7s/30s and
      10s/30s curve steepeners. If the market prices a June/July          Exhibit 2
      tapering, we will consider moving overweight duration and           UST 2s/7s/30s 50:50 Butterfly
      reentering our curve steepeners.
                                                                            Basis points running
                                                                           -15
There’s Action in Inaction
Chairman Bernanke’s comments on May 22 opened the door
for tapering to begin in “the next few meetings”, and this                 -22
helped fuel the sharp bond market sell-off. In addition to
bringing forward expectations of when tapering might begin,
the market pulled-in the expected timing of rate lift off. The             -29
market is pricing the first rate hike to occur in the first half of
2015, according to the Fed funds futures strip (see Exhibit 1).
                                                                           -36
This negatively affected the belly of the Treasury curve and
investors have become more wary of rolldown and carry
strategies as a result. Exhibit 2 shows how the highest carry              -43
and expected rolldown maturity on the Treasury curve
underperformed dramatically in the sell-off.
                                                                           -50
The simple interpretation of this market reaction is that the                Jan-12          May-12         Sep-12    Jan-13       May-13
market is now pricing tighter monetary policy relative to what it
                                                                          Source: Morgan Stanley Research


                                                                                                                                                6
                                                                            MORGAN STANLEY RESEARCH

                                                                            May 31, 2013
                                                                            US Interest Rate Strategist




Vice Chairman Dudley echoed similar remarks in a recent                     Enter Financial Conditions
interview. 1 The Fed’s view suggests that current monetary                  But should we even care about what the rates market thinks
policy is accommodative and becoming increasingly                           with respect to tighter or easier monetary policy? After all, the
accommodative each month it expands its balance sheet. If                   rates market alone does not provide a full picture of monetary
the Fed tapers purchases, they will be increasing                           policy accommodation. We have long argued that the Fed’s
accommodation at a slower rate, but increasing                              objective for unconventional policy is a holistic approach to
accommodation nevertheless. More broadly, we believe the                    ease financial conditions more broadly, including those found
Fed would say that it is easing monetary policy when it grows               in credit, equities and foreign exchange markets. For example
its balance sheet or lowers interest rates, and tightening policy           in a 2012 speech, New York Fed President Dudley
when it shrinks its balance sheet or raises interest rates.                 commented:

However, we believe the market thinks about Fed policy                             Lower long-term rates support the prices of equities
differently. The market has expectations about the future of                       and housing, boosting wealth and easing balance
policy much farther out than just the next month of purchases.                     sheet constraints, while an accommodative monetary
In the context of unconventional policy, we argue that the                         policy stance reduces downside risks for the economy
market fluidly adjusts its expectations with respect to future                     and this leads to lower default risk premia on
asset purchases and these adjustments constitute a forward-                        corporate debt. 2
looking assessment of whether current policy is easing or
tightening. Put another way, if markets expect asset                        Based on this and echoes of similar sentiment from other Fed
purchases of $85bn per month, and the Fed signals that it is                officials, we created our Morgan Stanley Financial Conditions
going to reduce that to $75bn, then the market prices in a                  Index (MSFCI) 3 . What is our MSFCI telling us about the
tightening of policy relative to what was in the price previously.          current state of policy amid recent Fed official actions?
                                                                            Financial conditions are actually easier today than they were
Another way to think about this dynamic is to associate large-              before the April non-farm payroll print that was the catalyst to
scale-asset purchases (LSAPs) with conventional policy. If the              rally in nominal Treasury markets (see Exhibit 3).
Fed believes that purchasing $85bn each month equates to a
25bp rate cut each quarter, for example, then tapering to                   Exhibit 3
$45bn each month would equate to a 25bp cut every six                       Morgan Stanley Financial Conditions Index
months. Thought about in this way, most investors would
                                                                                MSFCI
agree that the Fed is still easing policy even at a $45bn/month
pace because they are still “cutting” rates. But if the market                  1.5
                                                                                        Tighter
was priced for the Fed to cut rates 25bp every quarter, then                            Conditions
the market would price in tighter policy – relative to what it had              1.0
priced before – by pricing in a 25bp cut every six months.
                                                                                                                          Since the April
Returning to unconventional policy, the market’s interpretation                 0.5                                       NFP report,
                                                                                                                          conditions have
is consistent with the assertion that LSAP programs work
                                                                                                                          eased
through “stock” effects. Traditionally, forwarding looking
                                                                                0.0
markets priced in the expected size of the Fed’s balance
sheet when an LSAP program was announced. Given the
open-ended nature of the current program, the market has                        -0.5
                                                                                        Easier
linked the expected size of the Fed’s balance sheet to
                                                                                        Conditions
incoming economic data, and in particular the labor market
                                                                                -1.0
situation. As unemployment data get released, the market
adjusts its pricing based on the expected size of the Fed’s                       May-12         Aug-12         Nov-12         Feb-13         May-13
balance sheet relative to what was priced before the data.                  Source: Morgan Stanley Research


                                                                            2
                                                                              See Dudley, William, Remarks at the National Association for Business
                                                                            Economics Annual Meeting, New York City, October, 15, 2015.
                                                                            3
                                                                              The index is constructed using 10-year Treasury yields, the S&P500, 3-month
1
                                                                            T-Bill yields, and a broad-weighted dollar index. The MSFCI is available on
 http://www.bloomberg.com/video/dudley-discusses-taper-decision-mandates-   Bloomberg via MSFCI Index <GO>. For more information see our MSFCI primer
yellen-ms2Xe~MVRvCcUMNgU8gGuw.html                                          in US Interest Rate Strategist: Wait and See Mode, May 11 2012.

                                                                                                                                                       7
                                                                             MORGAN STANLEY RESEARCH

                                                                             May 31, 2013
                                                                             US Interest Rate Strategist




Easy Like Sunday Morning                                                     Exhibit 4
If Chairman Bernanke’s comments signaled impending policy                    History of SPX vs. 10-Year Treasury Yields during
tightening, then the MSFCI should have tightened, in our view.               Maturity Extension Program and QE∞
The change in the index is primarily due to increases in rates
                                                                               SPX
and equity prices, both of which are historically correlated with
easier financial conditions.                                                  1,800
                                                                                                 Sep 2011 - Sep 2012
                                                                              1,700              Sep 2012 - Current
Why are conditions easier if earlier tapering is a tightening of                                 Current
policy? We believe the answer lies in a prior analysis 4 we                   1,600
conducted on growth expectations. Alongside monetary
policy, growth expectations affect the price of equities and it is            1,500
the interplay between the two that drives financial conditions.               1,400
The Gordon Growth Model (GGM) – a simple equity pricing
model, relating equity prices to growth and discount rates –                  1,300
provides a useful framework for understanding this interplay.
                                                                              1,200
The GGM can be summarized as follows.
                                                                              1,100
                                     d
                                 P                                           1,000
                                    rg                                            1.25            1.50     1.75      2.00      2.25   2.50
                                                                                                      10-Year Treasury Yield (%)
                                                                             Source: Morgan Stanley Research
Where
                                                                             Leaning Against Growth but Not Derailing It
P = Equity Price                                                             The GGM provides insight into the ‘Goldilocks’ scenario for
d = Next year’s dividend                                                     the Fed: an environment where stronger growth prospects
g = Expected growth rate                                                     allow the Fed to tighten monetary policy without tightening
r = Discount rate                                                            overall financial conditions. In order to achieve such a
                                                                             scenario, growth expectations must be stable or rising,
Within this framework, equity prices can rise even as discount               relative to rates. How do Fed officials ensure that growth
rates rise, as long as growth expectations grow as well. In                  expectations remain buoyant at higher levels? In our view,
other words, equity prices may rise in spite of rising rates as              they continue to proceed along their present course – wait
long as expectations for growth outpace the rise in rates.                   until there is evidence of a sustainable improvement in the
While this notion contradicts an old equity adage, which states              labor market before tapering purchases. If growth is
that rising rates are bad for equities, it helps explain the recent          sustainable, growth expectations should remain elevated amid
equity/rate market behavior.                                                 a slow removal of accommodation.

Exhibit 4 plots the S&P 500 index price against interest rates               If the Fed were to tighten prematurely – perhaps by tapering
during the duration of the Maturity Extension Program and                    asset purchases too early – we would expect financial
QE∞. More recently, growth expectations have dominated the                   conditions to deteriorate, as the rise in growth expectations
relationship, resulting in a higher beta (more positive slope)               would be insufficient to offset the market’s pricing of tighter
between equities and rates. This suggests that the easing in                 monetary policy. In the two most recent episodes, where the
financial conditions, despite the tightening of Fed policy, can              Fed began to discuss exit strategies – at the close of QE1 and
be interpreted as an improvement in growth expectations.                     QE2 – financial conditions tightened appreciably (see Exhibit
                                                                             5). In the current environment that appears to have changed.
                                                                             Judging by our MSFCI, the Fed has so far been successful in
                                                                             embarking on the first steps of reducing accommodation
                                                                             without derailing growth expectations.


4
  See the US Treasury Inflation Protected Securities article within the US
Interest Rate Strategist: Return of the Fedi, March 22 2013.

                                                                                                                                          8
                                                                                            MORGAN STANLEY RESEARCH

                                                                                            May 31, 2013
                                                                                            US Interest Rate Strategist




Exhibit 5                                                                                   Exhibit 7
Morgan Stanley Financial Conditions Index                                                   Bloomberg US Economic Surprise Index
  MSFCI                                                                                         Z-score
  2.5                                                                                            1.2
  2.0                              QE2 Ends in                                                   1.0
                                   June 2011
  1.5                                                                                            0.8
  1.0                                                                        Tighter             0.6
                                                                          Conditions
  0.5                                                                                            0.4
  0.0                                                                                            0.2
 -0.5                                                                                            0.0
 -1.0                                                                                           -0.2
                                                                             Easier
 -1.5                                                                     Condition             -0.4

 -2.0                          QE1 Ends in                                                      -0.6
                               October 2009
 -2.5                                                                                           -0.8
   Jan-09             Jan-10           Jan-11            Jan-12          Jan-13                    Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14

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



Tick Tock on the Clock                                                                      If current yield levels correspond to a September tapering,
In a note published last week, we asserted that the market                                  they are inconsistent with our Chief US Economist Vincent
was pricing tapering to commence at the October 2013 FOMC                                   Reinhart’s view that December is the most likely timing of
meeting, based on our analysis of the impact of Fed                                         tapering 5 . In his view, the Fed needs to see net gains in
purchases. After the additional 10 basis point jump in yields                               nonfarm payrolls of at least of 200,000 for four more months
this week, we believe the market is priced for a September                                  to justify reducing the pace of purchases. His economic
start to tapering. Exhibit 6 provides an updated sensitivity                                forecasts imply December is the most likely start. As a result,
analysis of rate levels with respect to changes in the market’s                             there is a case to be made that going long duration makes
expectation for the timing of tapering. The analysis assumes                                sense from a tactical perspective, relative to our forecast for
that the market will pull in the expected timing of tapering and                            when tapering will begin. Our model suggests that 10-year
the expected timing of rate hikes. Therefore, the yield                                     yields would need to fall 28bp from current levels in order to
changes reflect (1) the expected change in term premiums for                                price in a December tapering. The risk, of course, is that
a given level of Fed duration take-out and (2) the expected                                 economic data outperform our expectations. And on that
change in the path of rate expectations associated with each                                score, the seasonality/cyclicality of economic surprise indexes
tapering scenario.                                                                          worry us. Exhibit 7 suggests we may be heading into a period
                                                                                            when economic data surprises – to the upside.
Exhibit 6
                                                                                            In addition, the volumes going through the Treasury market
Treasury Yields Expected Changes and Levels
                                                                                            have matched some of the largest averages we have seen in
Under Tapering Scenarios*
                                                                                            some time. Exhibit 8 shows how the average daily volume
                                5-Year        10-Year       30-Year
                                  Yield         Yield          Yield     10-Year Yield
                                                                                            over the past 21 trading days has risen to levels not seen
                               Change        Change         Change               Range      since October 2008. The volume spike that occurred between
Taper Begins…                      (bp)           (bp)          (bp)                 (%)    September and October 2008 – labeled 4 in the exhibit –
In June                              25            26             27         2.40-2.45      preceded one of the larger declines in Treasury yields we
In July                              14            14             15         2.25-2.30      have seen in recent times (see Exhibit 9, label 4). The other
In September                          0             0              0         2.10-2.15
                                                                                            high-volume “spikes” witnessed over the past decade either
In October**                        -11           -12            -12         2.00-2.05
In December                         -26           -28            -28         1.85-1.95      preceded large market moves (labels 1, 2, 4, 5, 7), occurred
No buying after June                 62            62             61         2.75-2.80      at the end of large market moves (labels 3, 7), or occurred in
Source: Morgan Stanley Research, * Assumes tapering schedule implied by the New York
Fed Primary Dealer Survey from March, ** Assumes market was priced for the first taper in
October when the NY Fed Primary Dealer Survey submissions were due.                         5
                                                                                                See Fed Focus: At the Movies with Ben Bernanke, May 28, 2013

                                                                                                                                                               9
                                                                   MORGAN STANLEY RESEARCH

                                                                   May 31, 2013
                                                                   US Interest Rate Strategist




the middle of large market moves (labels 6, 8). It is impossible   Exhibit 8
for us to know whether label 9 – representing the latest           ICAP Interdealer Broker Volumes:
volume spike – will precede a large move to higher rates, is       Bonds, Notes and Bills (21-Day Moving Average)
occurring in the middle of a move to higher rates, or
                                                                     US$ billions
represents the final hurrah in the move we have seen to
higher rates.                                                       500
                                                                                               2
Given the uncertainty in the marketplace – evidenced by high                                           3
volumes – and the risks to our economic outlook, we maintain        420                                    4                              9
                                                                                                                               7
our neutral stance toward duration. We will wait for the market                            1                               6       8
to price in an earlier tapering than the September FOMC
                                                                    340
meeting before going long duration. Because we think a                                                                5
June tapering is off-the-table (not enough labor market
data between now and then), and a July tapering is                  260
unlikely (not a meeting when the FOMC updates their
Summary of Economic Projections), we would prefer to
go long duration if/when the market prices a high                   180
likelihood of tapering at those meetings.

                                                                    100
Given the risks to higher yields in the near-term driven by
better-than-expected economic data, and our constructive             May-05             May-07             May-09         May-11        May-13
view on implied volatility, we relent on our 7s/30s and 10s/30s    Source: Morgan Stanley Research, Bloomberg, ICAP
yield curve steepeners. We suggest investors cut losses. We
did not appropriately measure the risk-reward of the trade,        Exhibit 9
and turn neutral on curve shape until we find our bearings         UST 10-Year Treasury Yield (21-Day Moving
again. When we feel the time is right to move overweight           Average)
duration, we will likely express that view by suggesting an
overweight to intermediate maturity Treasuries relative to the       %
wings (e.g., 2s/7s/30s or 2s/5s/10s butterflies) instead of         5.5
                                                                                               2
7s/30s or 10s/30s curve steepeners.
                                                                    5.0
                                                                    4.5
                                                                                          1                4
                                                                    4.0
                                                                                                                      5    7
                                                                    3.5                            3
                                                                    3.0                                                            8

                                                                    2.5
                                                                                                                          6               9
                                                                    2.0
                                                                    1.5

                                                                    1.0
                                                                     May-05            May-07              May-09         May-11       May-13

                                                                   Source: Morgan Stanley Research, Federal Reserve




                                                                                                                                              10
                                                                             MORGAN STANLEY RESEARCH


                                                                             May 31, 2013
                                                                             US Interest Rate Strategist



US Governments
Curve Steepeners Versus Volatility
Guneet Dhingra (212) 761-1445

                                                                              respectively. That would leave the curve levels precariously
         This past week’s spike in implied and realized volatility has
          brought our attention to the pricing of convexity in Treasuries.
                                                                              close to our stop-out levels (see Exhibit 5).
          Higher volatility can work against a 10s/30s steepener              An increase in volatility hurts the rolldown and carry cushion
          position via higher convexity being priced-in in the back end.      on the curve steepener in two ways. First, it simply reduces
         We think the rolldown and carry support for curve steepeners        the attractiveness of the RD&C on a risk adjusted basis.
          is dampened by the chances of an increase in volatility.            Second, an increase in volatility increases the chances of
          Thus, we move neutral on the 10s/30s curve.                         flattening (Exhibit 2) and thereby reduces the chances of the
         If we assume another 10bpv rise in 3m30y implied volatility,        RD&C cushion being enough. Given our view for higher
          the 10s/30s and the 7s/30s curves could flatten by 3.2bp and        implied volatility7, the RD&C argument for holding on to the
          4.4bp respectively, based on their regression with volatility.      10s/30s curve steepeners has weakened.
         For the upcoming 3s, 10s and 30s auctions, we recommend:
                                                                              Exhibit 1
         - 3-Year Auction: 3-year spread tightener; Enter: June 6             Yield Changes Under Tapering Scenarios**
           close, Exit: June 11 close
                                                                                                                    5-Year        7-Year     10-Year       30-Year
                                                                              Tapering Scenario
         - 10-Year Auction: Long 10s on 5s/10s/30s Fly (0.62 / 1.0                                                    Yield         Yield       Yield         Yield
           / 0.56) Enter: June 11 close, Exit: June 13 close                  Taper Begins in June*                   36bp          37bp        38bp          39bp
                                                                              Taper Begins in July*                   25bp          26bp        26bp          27bp
         - 30-Year Auction: Long 10s on 7s/10s/30s Fly (0.67/ 1.0             Taper Begins in September*              11bp          12bp        12bp          12bp
           / 0.37); Enter: June 10 close, Exit: June 20 close                 Taper Begins in October*                 0bp           0bp         0bp           0bp
                                                                              Taper Begins in December*              -15bp         -15bp       -16bp         -16bp
                                                                              MS Projected Schedule*                 -15bp         -15bp       -16bp         -16bp
Does Higher Volatility Pose Flattening Risks?                                 No Purchases Beyond Jun                 73bp          74bp        73bp          72bp
We have suggested 7s/30s and 10s/30s curve steepeners 6                       *Assumes the tapering schedule implied by the NY Fed Primary Dealer Survey in March
                                                                              ** The above table was created on May 23 – Rates have already moved higher since then,
since early May. In our most recent publication6 we showed                    closer to the levels implied by the ‘Tapering Begins in September’ scenario
                                                                              Source: Morgan Stanley Research, US Treasury
that the curve shape may not be significantly impacted by
changing expectations of tapering, as the combined effect of                  Exhibit 2
changes in rate expectations and term premiums is roughly                     10s/30s CMT Curve Vs 3m30y Implied Swaption
similar in the belly versus the long end (see Exhibit 1).                     Volatility (Post MEP Announcement)

However, this past week’s spike in implied and realized                          10s/30s CMT Curve
volatility (Exhibit 3) has brought our attention to the third                   125
                                                                                                                                     R2 = 64%
component of rates – convexity. Higher volatility can work
against a 10s/30s steepener position via increased convexity                    120
                                                                                            R2 = 0%                                  y = -0.32x + 141.53
being priced-in in the back end of the yield curve. If volatility               115
continues to rise, as we expect it to in the near term 7 , the
10s/30s steepener may be at risk. We respect this dynamic                       110
and go neutral on the 10s/30s curve.
                                                                                105
Flattening Risks Versus Rolldown And Carry                                                  10s/30s curve currently
                                                                                100         fair vs level of vol
We believe the risk of an increase in implied volatility is a
strong enough headwind for us to go neutral on the curve.                         95
According to the regression betas between the curve levels
                                                                                  90
and 3m30y implied volatility, a 10bpv rise in volatility could
                                                                                       50             70       90        110         130                      150
flatten the 10s/30s and the 7s/30s curves by 3.2bp and 4.4bp
                                                                                                      3m30y Implied Volatility (bpv)
                                                                              Source: Morgan Stanley Research
6
    US Interest Rate Strategy Insight: Don't Fear the Taper
7
    US Interest Rate Strategy Brief: The Revival of Volatility


                                                                                                                                                                 11
                                                                            MORGAN STANLEY RESEARCH


                                                                            May 31, 2013
                                                                            US Interest Rate Strategist




Exhibit 3                                                                    coincided with an increase in 11bpv in volatility – in line with
3m30y Implied & Realized Volatility (Past One Year)                          the relationship suggested by the scatter plot in Exhibit 2.
  bpv
                                                                             Exhibit 4
 120                                                                         10s/30s Curve Vs. 10-Year Rates (Past 9 Months)
                                                                               10s/30s Curve (bp)                                                   %
 106
                                                                              126.0                                                               2.4

   92                                                                                                                                             2.2
                                                                              120.8
                                                                                                                                                  2.0
   78                                                                         115.6                                                               1.8

   64                                                                         110.4                                                               1.6

                                                                                                                                                  1.4
   50                                                                         105.2
                                                                                                                                                  1.2
    Jun-12            Sep-12           Dec-12        Mar-13
            3m30y Implied Volatility            3m30y Realized Volatility     100.0                                                               1.0
                                                                                  Jul-12            Oct-12           Jan-13       Apr-13
Source: Morgan Stanley Research
                                                                                             10s/30s Curve                        10-Year CMT

What Drives the 10s/30s Curve?                                               Source: Morgan Stanley Research

Later in this section, we mathematically show how the
10s/30s (or the 7s/30s) curve can be modeled as a function                   Exhibit 5 shows our stop out levels on the 7s/30s curve. A
of two factors (1) the level of the implied volatility and (2) the           10bpv rise in 3m30y implied volatility flattens the 7s/30s
overall level of yields. Intuitively, higher volatility should lead          curve by 4.4bp as suggested by the long term regression.
to pricing in of increased convexity in the 30-year sector                   Assuming the relationship holds, a 10bpv rise in volatility
versus the 10-year sector, thereby flattening the 10s/30s                    would place the 7s/30 curve ~172bp, higher than our stop
curve. On the other hand, the 10s/30s curve has tended to                    out levels, albeit very slightly.
steepen (flatten) as yields have risen (fallen) in the period we
considered. While both factors are statistically significant, it is          Exhibit 5

the implied volatility that explains the bulk of the curve shape             7s/30s Curve After the MEP Announcement
over the period we considered (R2 between implied volatility                    7s/30s Curve (bp)
and 10s/30s curve = 65%).
                                                                               190

Exhibit 2 shows the relationship between the 10s/30s curve
and the 3m30y implied swaption volatility. We can see how                      178
the relationship has held reasonably well since the
announcement of the Maturity Extension Program (MEP).                          166
We chose the period after the MEP announcement as the
curve significantly repriced at that time, thereby trading in a                                                                7s/30s curve -
                                                                               154
new post-MEP regime. Exhibit 2 suggests that the 10s/30s                                                                       stop out : 170bp
curve currently looks fair to the level of implied volatility.
                                                                               142
The regression over the past nine months suggests that the
relationship of the curve to implied volatility was fairly weak                130
over this period. We think it was due to the low range bound                     Oct-11              Apr-12           Oct-12          Apr-13
implied volatility, and therefore the 10s/30s curve moved
                                                                                                                7s/30s Curve
more in line with the level of 10-year rates (see Exhibit 4).
However, the last 5bp flattening of the yield curve has                      Source: Morgan Stanley Research, CFTC




                                                                                                                                                        12
                                                                                    MORGAN STANLEY RESEARCH


                                                                                    May 31, 2013
                                                                                    US Interest Rate Strategist




Relating the 10s/30s Curve to Volatility                                             of open interest added in the past sixty days that is currently
One fundamental way to decompose Treasury yields is to                               offside. This high amount of open interest caught offside can
break them down into three components – (1) real world                               add fuel to the fire, if the selloff continues and these positions
expectation of policy rates (RE) (2) term premiums (TP) and                          get stopped out. Exhibit 7 shows the price point ranges at
(3) convexity 8 adjustments. The convexity adjustment                                which open interest was established in the TY contract over
reflects the price investors pay for the benefits of convexity                       the past sixty days.
and hence lowers the yield.
                                                                                     Exhibit 6
If we neglect the convexity embedded in the 10-year yields,                          Offside vs. Onside Positions in All Treasury
the rate expectations and term premiums component of 30-                             Futures Contracts Added in the Past Sixty Days
year yields can be assumed to be a multiple of rate                                  (10-Year Equivs)
expectations and term premiums in the 10-year yields. The
convexity in 30-year yields can then be captured by implied
volatility. The equation below sums up our framework thus
                                                                                       UL
far.
                                                                                      US
       β *(10y RE + 10y TP) ≈ β *(10y Yield – 10y Convexity) ≈ β *(10y Yield)


30 y Yield = 30 y Rate Expectations + 30 y Term Pr emium                               TY
                + 30 y Convexity Adjustment

                  3m30y Implied Volatility                                            FV


Based on modifying the equation above, the 10s/30s curve                               TU
can be modeled as a function of overall level of rates
(captured by 10-year CMT rate) plus a convexity component
(captured by 3m30y volatility). Thus from the equation                                      -25                                 -5                             15                               35
                                                                                                     $ billion notional (10-year equivalents)
above, we derive the following relationship:                                             Longs Onside                 Longs Offside                Shorts Onside              Shorts Offside
                                 RE & TP                  Convexity
                                                                                     Source: Morgan Stanley Research, CFTC

10 s / 30 s Curve = α * 10 y Yield + β * 30 y Im plied Vol + ε
                                                                                     Exhibit 7
                                                                                     Addition of Open Interest at Various Price Point
Thus we can attempt to model the 10s/30s curve (and
                                                                                     Ranges in the TY Contract over the Past Sixty Days
similarly the 7s/30s curve) using the regression equations
above. We found both variables to be statistically significant                          $ billion
                                                                                                                               Current
at a confidence level of 99%. However, it is notable that                                15
                                                                                                                               Price
when we looked at the 10s/30s curve with volatility as the                                                                                                   Longs offside
only input variable, the regression R2 was 65%, versus a                                 10
modest increase to 69% when we used both the volatility and
the 10-year yield as inputs.                                                              5

Positioning Imbalance Tracker                                                             0
We define the positioning imbalance 9 on a given day as the
percentage of open interest added in the contract in the past                            -5
sixty days that is currently offside. Exhibit 6 shows the total
open interest caught offside and onside in 10-year                                      -10
                                                                                                  -0-141

                                                                                                            130-040

                                                                                                                      +0-141

                                                                                                                                 +0-281

                                                                                                                                          +1-102

                                                                                                                                                   +1-242

                                                                                                                                                            +2-063

                                                                                                                                                                     +2-203

                                                                                                                                                                              +3-02+

                                                                                                                                                                                       +3-16+




equivalents across the five Treasury futures contracts as of
May 31. The FV, TY and the UL contracts have nearly 70%

8                                                                                                          Longs                          Shorts                     Current Price
  Convexity implies a bond gains more in a decline in yield, and loses less in an
equivalent increase in yield, than what duration would imply
9                                                                                    Source: Morgan Stanley Research, CFTC
  US Interest Rate Strategist: A New Hope, March 8, 2013


                                                                                                                                                                                                 13
                                                                                                                       MORGAN STANLEY RESEARCH


                                                                                                                       May 31, 2013
                                                                                                                       US Interest Rate Strategist




Setting Up for the 3s, 10s and 30s Auctions                                                                             Exhibit 9
We suggest optimal entry and exit timing for trades around                                                              5s/10s/30s Fly Move (Past Twelve 10Y Auctions)
the upcoming 3-, 10- and 30-year Treasury auctions (for                                                                                                                                           Hits in Last           Average Move
                                                                                                                        Enter On                                 Exit On                             Year                 in Profit (bp)
details on our trade selection, refer to US Interest Rate
                                                                                                                        June 11 close                         June 13 close                            10                      0.7
Strategist: A New Hope, March 8, 2013). For each tenor, we
list an outright long/short and top two curve and butterfly                                                                                                                                                                             bp
trades. We sort the trades based on the highest hits (i.e.                                                                                                                                                                              2.0
instances of profit) in the past one year, followed by the
                                                                                                                                                                                                                                        1.5
highest Sharpe ratios. We calculate the Sharpe ratio by
dividing the average PNL of the strategy by the average                                                                                                                                                                                 1.0
volatility of the strategy over the past twelve auction cycles.                                                                                                                                                                         0.5
                                                                                                                                                                                                                                        0.0
We also looked at these trades on swap spreads. Appendix
A and B in this section show the top trades for all tenors                                                                                                                                                                              -0.5
using PCA-weighted yields and swap spreads. The risk to                                                                                                                                                                                 -1.0
the auction trades is that they do not move in line with their
recent trends.                                                                                                                                                                                                                          -1.5




                                                                                                                                                                       Nov 12
                                                                                                                          Jun 12

                                                                                                                                   Jul 12




                                                                                                                                                                                         Jan 13
                                                                                                                                                              Oct 12



                                                                                                                                                                                Dec 12




                                                                                                                                                                                                                      Apr 13
                                                                                                                                            Aug 12

                                                                                                                                                     Sep 12




                                                                                                                                                                                                    Feb 13

                                                                                                                                                                                                             Mar 13



                                                                                                                                                                                                                               May 13
3-Year Auction: Enter a 3-Year Spread Tightener
Exhibit 8 below shows the optimal entry dates for the 3-year                                                                                 5s/10s/30s Move (1 day before - 1 days after)
spread tightener around the 3-year auction and the trade’s
                                                                                                                        Source: Morgan Stanley Research
performance over the past twelve 3-year auctions.

Exhibit 8                                                                                                               30-Year Auction: Long 10s on 7s/10s/30s PCA Weighted
3-Year Spread Move (Past Twelve 3Y Auctions)                                                                            Fly (0.67/1.0/0.37)
                                                                          Hits in Last           Average Move
                                                                                                                        Exhibit 10 below shows the optimal entry dates for the
Enter On                                 Exit On                             Year                 in Profit (bp)
                                                                                                                        7s/10s/30s PCA weighted butterfly around the past twelve
June 6 close                          June 11 close                            10                      1.3
                                                                                                                        30-year auctions.
                                                                                                                bp
                                                                                                                1.0     Exhibit 10
                                                                                                                        7s/10s/30s Fly Move (Past Twelve 30Y Auctions)
                                                                                                                0.5
                                                                                                                                                                                                  Hits in Last           Average Move
                                                                                                                0.0     Enter On                                 Exit On                             Year                 in Profit (bp)
                                                                                                                -0.5    June 10 close                         June 20 close                            11                      1.0

                                                                                                                -1.0                                                                                                                    bp

                                                                                                                -1.5                                                                                                                    1.5

                                                                                                                -2.0                                                                                                                    1.0
                                                                                                                                                                                                                                        0.5
                                                                                                                -2.5
                                                                                                                                                                                                                                        0.0
                                                                                                                -3.0
                                                                                                                                                                                                                                        -0.5
                                               Nov 12
  Jun 12

           Jul 12




                                                                 Jan 13
                                      Oct 12




                                                                                              Apr 13
                    Aug 12

                             Sep 12




                                                        Dec 12



                                                                            Feb 13

                                                                                     Mar 13



                                                                                                       May 13




                                                                                                                                                                                                                                        -1.0
                                                                                                                                                                                                                                        -1.5
                     3y Spreads Move (3 day before - 0 days after)                                                                                                                                                                      -2.0
                                                                                                                                                                                                                                        -2.5
Source: Morgan Stanley Research
                                                                                                                                                                                                                                        -3.0
                                                                                                                                                                       Nov 12
                                                                                                                          Jun 12

                                                                                                                                   Jul 12




                                                                                                                                                                                         Jan 13
                                                                                                                                                              Oct 12



                                                                                                                                                                                Dec 12




                                                                                                                                                                                                                      Apr 13
                                                                                                                                            Aug 12

                                                                                                                                                     Sep 12




                                                                                                                                                                                                    Feb 13

                                                                                                                                                                                                             Mar 13



                                                                                                                                                                                                                               May 13




10-Year Auction: Long 10s on 5s/10s/30s PCA Weighted
Fly (0.62/1.0/0.56)
Exhibit 9 below shows the optimal entry dates for the                                                                                        7s/10s/30s Move (3 day before - 5 days after)
5s/10s/30s PCA fly and how it moved around the past twelve
                                                                                                                        Source: Morgan Stanley Research
10-year auctions.

                                                                                                                                                                                                                                          14
                                                                                                        MORGAN STANLEY RESEARCH


                                                                                                        May 31, 2013
                                                                                                        US Interest Rate Strategist




Appendix A: Top PCA Weighted Trades Around Treasury Auctions
2-Year Auction
                                                               Days Before          Days After                                              Avg Move in        Top Three Profits         Sharpe
Trade                                                            Auction             Auction          Hits In Last Year Avg Move             Profit (bp)               (bp)               Ratio
Long 2y                                                             0                   5                     10          -1.7                  -2.3            -4.1 , -3.2 , -3.1         0.8
2s/3s Steepener (1.9/1.0)                                           0                   5                     11           0.7                   0.8             2.1 , 1.5 , 1.5           0.6
2s/5s Steepener (3.7/1.0)                                           0                   6                     10           2.3                   3.3             7.9 , 6.8 , 5.0           0.5
2s/3s/5s Fly -Short (1.08 / 1.0 / 0.21)                             1                   4                     10           0.5                  0.7              1.4 , 1.4 , 1.2           0.5
2s/5s/10s Fly -Long (2.35 / 1.0 / 0.25)                             1                   1                     9           -0.7                  -1.5            -2.7 , -2.1 , -2.0         0.5

3-Year Auction
                                                               Days Before          Days After                                              Avg Move in        Top Three Profits         Sharpe
Trade                                                            Auction             Auction          Hits In Last Year Avg Move             Profit (bp)               (bp)               Ratio
Short 3y                                                            4                   0                     10           2.0                  2.8               4.8 , 4.5 , 4.0          0.7
3s/5s Steepener (2.0/1.0)                                           0                   3                     9            1.2                  1.7              4.8 , 2.6 , 2.3           0.7
3s/10s Steepener (2.9/1.0)                                          0                   3                     9            1.6                  3.3              12.8 , 5.3 , 2.6          0.4
2s/3s/5s Fly -Long (1.08 / 1.0 / 0.21)                              1                   0                     11          -0.2                  -0.2            -0.4 , -0.3 , -0.3         0.9
3s/5s/7s Fly -Short (1.24 / 1.0 / 0.28)                             0                   1                     9            0.2                  0.5              1.2 , 1.1 , 0.6           0.4

5-Year Auction
                                                               Days Before          Days After                                              Avg Move in        Top Three Profits         Sharpe
Trade                                                            Auction             Auction          Hits In Last Year Avg Move             Profit (bp)               (bp)               Ratio
Long 5y                                                             0                   4                     11          -2.5                  -3.0            -7.5 , -4.3 , -4.1         0.5
3s/5s Flattener (2.0/1.0)                                           2                   0                     10          -1.5                  -1.9            -5.2 , -4.0 , -2.6         0.9
5s/10s Steepener (1.5/1.0)                                          1                   4                     10           2.2                  3.4              6.5 , 5.9 , 5.6           0.7
2s/5s/10s Fly -Short (2.35 / 1.0 / 0.25)                            0                   4                     9            1.1                  1.7              3.3 , 3.1 , 2.3           0.6
3s/5s/7s Fly -Long (1.24 / 1.0 / 0.28)                              2                   0                     11          -0.6                  -0.8            -2.3 , -1.2 , -1.0         0.8

7-Year Auction
                                                               Days Before          Days After                                              Avg Move in        Top Three Profits         Sharpe
Trade                                                            Auction             Auction          Hits In Last Year Avg Move             Profit (bp)               (bp)               Ratio
Long 7y                                                             3                   5                     11          -6.6                  -7.7           -23.4 , -17.9 , -9.3        0.6
5s/7s Steepener (1.3/1.0)                                           2                   1                     10           1.2                  1.6              3.1 , 2.4 , 2.1           0.9
7s/10s Steepener (1.1/1.0)                                          3                   3                     10           1.2                  1.6              3.8 , 3.2 , 2.2           0.7
2s/7s/10s Fly -Short (1.42 / 1.0 / 0.66)                            0                   3                     10           0.5                  0.7              1.6 , 1.2 , 1.1           0.5
5s/7s/10s Fly -Long (0.60 / 1.0 / 0.51)                             4                   0                     9           -0.4                  -0.7            -1.9 , -1.5 , -1.4         0.6

10-Year Auction
                                                               Days Before          Days After                                              Avg Move in        Top Three Profits         Sharpe
Trade                                                            Auction             Auction          Hits In Last Year Avg Move             Profit (bp)                (bp)              Ratio
Short 10y                                                           6                   0                      9           5.5                   9.8            18.9 , 15.4 , 12.8         0.5
5s/10s Flattener (1.5/1.0)                                          2                   3                     9           -0.8                  -2.4             -6.8 , -2.6 , -2.5        0.2
5s/10s/30s Fly -Long (0.62 / 1.0 / 0.56)                            1                   1                     10          -0.5                  -0.7             -1.3 , -1.1 , -1.0        0.6
7s/10s/30s Fly -Long (0.67 / 1.0 / 0.37)                            2                   6                     11          -0.8                  -1.0             -2.5 , -1.4 , -1.3        0.8

30-Year Auction
                                                               Days Before          Days After                                              Avg Move in        Top Three Profits         Sharpe
Trade                                                            Auction             Auction          Hits In Last Year Avg Move             Profit (bp)                (bp)              Ratio
Long 30y                                                            1                   2                      9          -1.2                  -4.4           -11.8 , -10.1 , -4.8        0.2
5s/30s Flattener (1.5/1.0)                                          5                   2                     9           -1.6                  -4.6            -10.8 , -9.8 , -5.2        0.2
5s/10s/30s Fly -Long (0.62 / 1.0 / 0.56)                            2                   0                     10          -0.4                  -0.7             -1.3 , -1.1 , -1.0        0.6
7s/10s/30s Fly -Long (0.67 / 1.0 / 0.37)                            3                   5                     11          -0.8                  -1.0             -2.5 , -1.4 , -1.3        0.8
* All Treasuries and spreads are based on constant maturity rates to avoid discontinuities
** Days before and after represent the close levels on those days. For example, enter 2 days before auction suggests entering the trade at the closing levels two business days before the auction
*** Average move is shown for all times the trade profited. The magnitude of the overall average move (including the times the trade lost money) is lesser than the average move in profit shown
**** Sharpe ratio is calculated as the average PNL in the past twelve auctions divided by the average volatility of the trade in the past twelve cycles
Source: Morgan Stanley Research




                                                                                                                                                                                                 15
                                                                                                        MORGAN STANLEY RESEARCH


                                                                                                        May 31, 2013
                                                                                                        US Interest Rate Strategist



Appendix B: Top Spread Trades Around Treasury Auctions
2-Year Auction
                                                                      Days Before             Days After          Hits In Last        Avg Move in          Top Three Profits            Sharpe
Trade                                                                   Auction                Auction               Year              Profit (bp)                 (bp)                  Ratio
Long 2y Spreads                                                            4                      1                     9                  1.4               3.2 , 2.5 , 1.7              0.4
2s/3s Spreads Flattener (1.0/1.0)                                          0                      1                    10                 -0.6              -1.1 , -0.8 , -0.8            0.8
2s/5s Spreads Steepener (1.0/1.0)                                          3                      5                    10                  1.1               2.9 , 2.9 , 2.0              0.4
2s/3s/5s Spreads Fly -Short (0.50 / 1.0 / 0.50)                            0                      2                    12                 -0.5              -1.3 , -0.9 , -0.7            0.9
2s/5s/10s Spreads Fly -Long (0.50 / 1.0 / 0.50)                            0                      3                     9                  0.4               1.1 , 0.9 , 0.7              0.5

3-Year Auction
                                                                      Days Before             Days After          Hits In Last        Avg Move in          Top Three Profits            Sharpe
Trade                                                                   Auction                Auction               Year              Profit (bp)                 (bp)                  Ratio
Short 3y Spreads                                                           5                      0                    11                 -1.9              -7.0 , -2.4 , -2.4            1.0
3s/5s Spreads Flattener (1.0/1.0)                                          2                      1                    10                 -0.5              -1.5 , -1.2 , -0.9            0.5
3s/10s Spreads Steepener (1.0/1.0)                                         6                      6                    10                  2.3               8.7 , 5.1 , 3.6              0.5
2s/3s/5s Spreads Fly -Long (0.50 / 1.0 / 0.50)                             0                      1                    10                  0.3               0.6 , 0.5 , 0.4              0.6
3s/5s/7s Spreads Fly -Short (0.50 / 1.0 / 0.50)                            0                      2                    10                 -0.3              -0.7 , -0.6 , -0.4            0.0

5-Year Auction
                                                                      Days Before             Days After          Hits In Last        Avg Move in          Top Three Profits            Sharpe
Trade                                                                   Auction                Auction               Year              Profit (bp)                (bp)                   Ratio
Long 5y Spreads                                                            2                      2                    11                 1.2                2.9 , 2.3 , 1.4              0.6
3s/5s Spreads Steepener (1.0/1.0)                                          2                      1                    11                 1.0                2.0 , 1.6 , 1.5              1.1
2s/5s/10s Spreads Fly -Long (0.50 / 1.0 / 0.50)                            0                      1                    11                 0.3                0.7 , 0.4 , 0.4              0.9
3s/5s/7s Spreads Fly -Long (0.50 / 1.0 / 0.50)                             0                      1                    11                 0.3                0.7 , 0.6 , 0.3              0.9

7-Year Auction
                                                                      Days Before             Days After          Hits In Last        Avg Move in          Top Three Profits            Sharpe
Trade                                                                   Auction                Auction               Year              Profit (bp)                 (bp)                  Ratio
Long 7y Spreads                                                            5                      5                    10                  2.9               8.4 , 5.8 , 4.4              0.8
5s/7s Spreads Steepener (1.0/1.0)                                          4                      5                    10                  1.9               7.1 , 2.8 , 2.5              0.9
7s/10s Spreads Flattener (1.0/1.0)                                         4                      3                     9                 -1.0              -2.5 , -1.7 , -1.6            0.4
2s/7s/10s Spreads Fly -Long (0.50 / 1.0 / 0.50)                            3                      5                    10                  1.6               2.9 , 2.6 , 2.6              0.9
5s/7s/10s Spreads Fly -Long (0.50 / 1.0 / 0.50)                            4                      3                    11                  1.0               2.9 , 2.1 , 1.3              0.6

10-Year Auction
                                                                      Days Before             Days After          Hits In Last        Avg Move in          Top Three Profits            Sharpe
Trade                                                                   Auction                Auction               Year              Profit (bp)                 (bp)                  Ratio
Short 10y Spreads                                                          3                      0                    10                 -1.4              -2.9 , -2.4 , -2.0            0.9
5s/10s Spreads Steepener (1.0/1.0)                                         6                      5                     9                  2.2               5.0 , 3.2 , 3.1              0.5
7s/10s Spreads Steepener (1.0/1.0)                                         6                      6                    10                  2.3               4.5 , 4.1 , 3.5              0.8
5s/10s/30s Spreads Fly -Short (0.50 / 1.0 / 0.50)                          3                      0                     9                 -0.7              -1.9 , -1.5 , -1.4            0.5
7s/10s/30s Spreads Fly -Long (0.50 / 1.0 / 0.50)                           2                      2                    10                  0.9               2.4 , 2.3 , 1.1              0.6

30-Year Auction
                                                                      Days Before             Days After          Hits In Last        Avg Move in          Top Three Profits            Sharpe
Trade                                                                   Auction                Auction               Year              Profit (bp)                (bp)                   Ratio
Long 30y Spreads                                                           0                      1                     9                 0.8                1.3 , 1.0 , 1.0              0.8
5s/30s Spreads Steepener (1.0/1.0)                                         6                      2                    10                 2.3                4.5 , 4.3 , 3.9              0.6
7s/30s Spreads Steepener (1.0/1.0)                                         5                      1                    11                 2.1                5.4 , 4.5 , 3.3              0.7
5s/10s/30s Spreads Fly -Long (0.50 / 1.0 / 0.50)                           3                      4                     9                 0.9                2.3 , 1.9 , 1.1              0.2
7s/10s/30s Spreads Fly -Long (0.50 / 1.0 / 0.50)                           3                      1                    10                 0.9                2.4 , 2.3 , 1.1              0.6
* All Treasuries and spreads are based on constant maturity rates to avoid discontinuities
** Days before and after represent the close levels on those days. For example, enter 2 days before auction suggests entering the trade at the closing levels two business days before the auction
*** Average move is shown for all times the trade profited. The magnitude of the overall average move (including the times the trade lost money) is lesser than the average move in profit shown
**** Sharpe ratio is calculated as the average PNL in the past twelve auctions divided by the average volatility of the trade in the past twelve cycles
Source: Morgan Stanley Research




                                                                                                                                                                                                 16
                                                                           MORGAN STANLEY RESEARCH

                                                                           May 31, 2013
                                                                           US Interest Rate Strategist




U.S. Treasury Inflation-Protected Securities
Is There an End in Sight?
Tiffany Wilding (212) 761-4415                                              Reallocation Reflects Real Duration Fears
                                                                            In our view, the continued allocation out of the asset is not a
     Summary                                                                reflection of a meaningful shift lower in inflation expectations
                                                                            or rising deflation fears, per se. Rather we believe investors
        TIPS continued to trade poorly this week, as end-users
          continued to reallocate out of the product. We believe the
                                                                            are concerned about the duration exposure of TIPS amid an
          catalyst of the reallocation is duration – and not deflation –    environment where (1) inflation is modest and stable and (2)
          fears, and we expect these flows will continue if rates           broader interest rates are rising. Recall that outflows began
          markets continue to sell off.                                     in December and accelerated in February before the
                                                                            economic data began to deteriorate.
        TIPS valuations continue to look fair to us – not cheap –
          and we cannot ignore the technical factors underlying the
          product. It’s no secret that TIPS are a relatively illiquid
                                                                            A more detailed look at the underlying data provides
          asset class. Therefore, we believe that forced selling from       evidence of our assertion about the drivers of the
          end-user redemptions implies US inflation markets could           reallocations. The inflation-linked asset class has seen
          see some near-term cheapening as real rate risk changes           outflows, but there has also been a broader reallocation
          hands.                                                            away from funds that track the entire universe of TIPS to
                                                                            funds that track only TIPS with <5 years time to maturity. In
        We like positioning for this cheapening by being tactically
         short 10-year breakevens outright or entering into 5s/30s
                                                                            other words, real return investors are shortening the duration
         breakeven steepener trades. The shape of the breakeven             of their TIPS allocation within their broader portfolio (see
         curve has been directional with the level of breakevens.           Exhibit 1). This is consistent with our story that duration
                                                                            concerns are driving the underling trends.
     Trade: Short 10-Year Breakevens
     Trade: 5s/30s Breakeven Steepeners                                     Exhibit 1
                                                                            TIPS Mutual Fund and ETF Flows
TIPS Trade Like a Leaky Tire – Slow and Steady                                $ Billions
The TIPS market resumed trading poorly this week. We
                                                                              2.5
attribute the poor performance to continuation of an end-user
reallocation out of the product that started in December and                  2.0
has continued amid the broader rates market selloff. We                       1.5
have not received May institutional investor flows data, but
our real time metrics, 10 which we use as an early proxy for                  1.0
the institutional data, continue to point to outflows.                        0.5
                                                                              0.0
We were somewhat surprised by how poorly the asset class
traded this week, after what appeared to be a decent 10-year                 -0.5
auction result. Treasury was able to issue $13 billion 10-year               -1.0
TIPS 2 basis points above prevailing market levels; however,
underlying auction statistics were relatively strong. Primary                -1.5
dealer concentration was the lowest on record and indirect                   -2.0
bidders were awarded 93% of their tenders. To us the
                                                                             -2.5
auction statistics suggested that there are marginal buyers at
                                                                                 Apr 11           Oct 11          Apr 12     Oct 12          Apr 13
these levels. Still, those marginal buyers appeared to be
more apprehensive this week.                                                               <5yr TTM Funds                  All Other Funds

                                                                            Source: Morgan Stanley Research, Simfund


                                                                            The average duration of mutual funds and ETFs that track
                                                                            the TIPS market is around 9 years. Similar style funds that
10
  Are real time metrics are based on TIPS ETF net asset value and           track the nominal Treasury have 4.5 to 5-year duration. We
shares outstanding data.

                                                                                                                                                 17
                                                                     MORGAN STANLEY RESEARCH


                                                                     May 31, 2013
                                                                     US Interest Rate Strategist


concede that to make an apples-to-apples comparison                   Exhibit 2
between real and nominal duration, investors must apply a             Bloomberg US Economic Surprise Index
forward looking assumption about the correlation between
                                                                       Z-score
real and nominal interest rates. We call this the “beta”
adjustment which translates real duration into effective                1.2
nominal duration terms. Historically, real rates have followed          1.0
nominal rates with a “beta” of 70% to 80%. In other words for
                                                                        0.8
every 10 basis point rise in nominal rates, TIPS have tended
to rise 7 to 8 basis points. In general, betas have been lower          0.6
in the post crisis trading regime; however, more recently,              0.4
correlations have been rising. Over the last week the TIPS              0.2
vs. nominal beta has been closer to 1, increasing the
effective nominal duration of TIPS.                                     0.0
                                                                       -0.2
Is There an End in Sight?                                              -0.4
In regard to this reallocation, is there an end in sight? Maybe
not. If the driver is mainly duration fears – not deflation fears      -0.6
– the reallocation will likely continue. The selloff in broader        -0.8
rates markets since Fed chairman Bernanke’s testimony                     Jan 11 Jul 11 Jan 12 Jul 12 Jan 13 Jul 13 Jan 14
appears to be the catalyst for this week’s weakness in TIPS.
                                                                      Source: Morgan Stanley Research, Bloomberg
Therefore, if rates markets continue to sell off, TIPS will likely
underperform – real rates will likely market higher.
                                                                      Exhibit 3

We continue to expect 10-year nominal rates to end 2013 at            Term Structure of 1-Year Forward Breakevens
2.29%, but we will revise our forecasts higher if economic
                                                                       %
growth continues to surprise to the upside. US economic
surprise indices have turned upward. Trends in that series             2.8
suggest that the risk is that data surprises to the upside (see
Exhibit 2)                                                             2.5

Valuations Look ‘Fair’ Not ‘Cheap’                                     2.3
Based on our view that outflows will continue, the question
becomes – “at what level will the marginal buyer step in to            2.0
buy TIPS?” Despite the selloff, valuations still look ‘fair’ to us
– not ‘cheap.’ The 5y5y forward breakeven, the most                    1.8
watched measure by the Federal Reserve, has remained
                                                                                                                   3/15/2013       Today
remarkably stable at the 2.5% level. We believe this level is          1.5
important because it is roughly in line with the Fed’s formal                                                      QE∞
long-term inflation target (2% PCE + 50 basis points for the
                                                                       1.3
spread between PCE and CPI).
                                                                              0             2             4            6       8           10
                                                                                                        Time to Maturity
Further, we highlighted last week that shorter-dated forward
                                                                      Source: Morgan Stanley Research, Bloomberg
breakevens have also been relatively stable and currently
only look ‘fair’. To measure movements in shorter-dated
forwards we turn to the term structure of 1-year forward              Based on increased market discussion about disinflation or
breakevens. It is true that the short end of the 1-year forward       even outright deflation, we are somewhat surprised to find
breakeven curve has led breakevens lower since the March              shorter-dated forward breakevens aren’t trading lower.
15, 2013, peak in breakeven levels. However, we compare               Indeed our economics team believes downside risks to
the current breakeven levels to those that prevailed prior to         consumer price inflation are larger now than they were last
the announcement of QE∞, and find they are trading at or              September, owing to the glut of multifamily housing supply
above those levels (see Exhibit 3).                                   that is expected to come to market in 2014. Why are short-
                                                                      dated forwards still above pre-QE∞ levels, despite increased



                                                                                                                                           18
                                                                   MORGAN STANLEY RESEARCH


                                                                   May 31, 2013
                                                                   US Interest Rate Strategist


risks to near-term inflation? In our view, there are two            Exhibit 4
possible reasons –                                                  Core PCE vs. Our Discretionary Component Index
                                                                      %                                                                  %
  (1) End-users appear to be reallocating out of the asset
      class, but as we highlighted earlier in the piece, there        3.5                                                            5.0
      is also evidence they are reallocating within the real          3.0                                                            4.5
      yield curve. We’ve seen large inflows into short-dated          2.5                                                            4.0
      TIPS and we’ve seen increased interest from end-
                                                                      2.0                                                            3.5
      users to own TIPS mutual funds that are
      benchmarked to shorter-duration real indices. In a              1.5                                                            3.0
      rising rate environment, we expect these trends will            1.0                                                            2.5
      continue.                                                       0.5                                                            2.0
                                                                      0.0                                                            1.5
  (2) Fed officials continue to downplay disinflationary
      trends in price indexes, because longer-term inflation         -0.5                                                            1.0
      expectations are stable. The most recent FOMC                  -1.0                                                            0.5
      minutes stated that the disinflationary trends stemmed         -1.5                                                            -
      from “temporary” factors. Moreover, the market has               Jan 90         Jan 95        Jan 00     Jan 05   Jan 10
      received indications from some Fed officials that they                     Discretionary Components               Core PCE (rhs)
      are not revising down their two-year-ahead inflation
      forecast, because longer-term inflation forecasts are         Source: Morgan Stanley Research, Simfund

      anchored. Since we expect longer-term TIPS
      breakevens to remain anchored, to us this suggests            Piecing It All Together
      that shorter-dated forwards might not fall much more          Where does all of this leave us? Our long and short-term
      from current levels.                                          inflation expectations are not materially different from those
                                                                    we held at the beginning of the year, hence we do not
PCE Reflects “Temporary” Factors?                                   fundamentally believe breakeven’s should be free falling.
Friday’s PCE reading reflected continued weakness in core           However, we cannot ignore the difficult underlying
PCE levels. Core PCE inflation slowed to 1.05% on a year-           supply/demand factors within the asset class. It’s no secret
on-year basis. The “distortions” in core PCE highlighted by a       that TIPS markets are relatively illiquid. This coupled with
recent Hilsenrath WSJ article appears have abated. Indeed,          forced selling from end-user redemptions implies US inflation
the market-based measure, which excludes non-market                 markets could see some near-term cheapening as real rate
components like financial services, printed at 1.1% year-           risk changes hands. Moreover, we see valuations across the
over-year in April, which was very close to overall core PCE        curve as ‘fair’ but not ‘cheap.’
of 1.05%. Still, the core components contributing to the
weakness in PCE (and also CPI) continued to be
components related to “discretionary” spending, including
recreational services and goods, vehicles, furnishings and
transportation services. These items tend to be more cyclical
and lag broader growth indicators. Based on this, perhaps it
is not surprising that Fed officials are not revising down their
near-term forecasts – after all, we continues to get
indications that growth and unemployment are improving.
Consistent with this, our economics team has not revised
down their near-term inflation forecasts and continue to
believe growth and inflation will begin to pick up in the
second half of the year.

Exhibit 4 compares a simple series of these core
“discretionary” items with the PCE index – equally weighted
– with the recent dynamics in the broader core PCE. As the
exhibit illustrates, these more cyclical items are driving the
disinflation in core inflation.


                                                                                                                                         19
                                                                      MORGAN STANLEY RESEARCH


                                                                      May 31, 2013
                                                                      US Interest Rate Strategist


Exhibit 5                                                              breakevens and the breakeven curve are sensitive to
10-year Breakeven vs. 5s/30s Breakeven Curve                           movements in energy commodities markets. The pass-
                                                                       through of wholesale gasoline inflation onto consumer price
 10-Year Breakeven (%)                       y = -1.5364x + 2.7494
                                                                       inflation is relatively stable and easy to model. Hence, a rise
 2.60                                                                  in energy prices could adversely impact these trades. For
                                                                       now, we are comfortable taking the risk because energy
                                                                       markets have underperformed due to weak Chinese growth.
                                                                       Our China economists expect this trend to continue.
 2.40
                                                                       Exhibit 6
                                                                       10-year Breakeven

 2.20                                                                    %
                                                                         2.9

                                                                         2.7

 2.00                                                                    2.5
     0.15       0.20      0.25     0.30 0.35 0.40 0.45         0.50      2.3
                                  5/s30s Breakeven (%)
                                                                         2.1
Source: Morgan Stanley Research, Bloomberg
                                                                         1.9
Based on this, we like tactically positioning short 10-year              1.7
breakevens, and entering breakeven steepener trades. The
                                                                         1.5
level of breakevens tends to be directional with the
breakeven curve. This has been especially true since the                 1.3
beginning of April (see Exhibit 5).                                       Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13
                                                                                   10-year Breakeven                Target     Stop Loss
Trade: Short 10-Year Breakevens
                                                                       Source: Morgan Stanley Research, Bloomberg

           Sell $100 million TII 0.125% 1/12/2023
                                                                       Exhibit 7

           Buy $108 million T 2% 2/15/2023                            5s/30s Breakeven Curve
                                                                          %
The risk to the trade is that breakevens widen. 10-year
                                                                           1.3
Breakevens are currently trading at 2.18. We set our target
and stop loss on the trade at 2.10% and 2.30% respectively                 1.1
(see Exhibit 6).
                                                                           0.9

Trade: 5s/30s Breakeven Steepeners (50:50)                                 0.7

                                                                           0.5
           Sell $100 million TII 0.125% 4/15/2018
                                                                           0.3
           Buy $100 million T 0.625% 4/30/2018
                                                                           0.1
           Buy $100 million TII 0.625% 2/15/2043                         -0.2
                                                                             Jan 10 Jul 10 Jan 11 Jul 11 Jan 12 Jul 12 Jan 13
           Sell $140 million T 3.125% 2/15/2043                                   5s/30s Breakeven Curve             Target   Stop Loss

                                                                       Source: Morgan Stanley Research, Bloomberg
The risk to the trade is that the breakeven curve flattens. The
5s/30s breakeven curve is currently trading around 40 basis
points (see Exhibit 7). We set our target level and stop out
at 60 and 35 basis points respectively. Traditionally, TIPS


                                                                                                                                           20
                                                                     MORGAN STANLEY RESEARCH


                                                                     May 31, 2013
                                                                     US Interest Rate Strategist



US Short Duration Strategy
Awaiting Reforms
Subadra Rajappa (212) 761-2983                                        June 28. Typically quarter-end balance sheet constraints
                                                                      tend to push overnight repo rates higher. The large cash
                                                                      payment from the GSEs could exacerbate such a move.
     Overnight repo rates fell precipitously over the last two
       weeks, averaging in the low single digits.
                                                                      Exhibit 1
     Although the seasonal decline in Treasury bill supply is the
                                                                      Spot and Future GCF Treasury Repo Rates
       primary driver of lower repo rates, the recent decline in
       primary dealer securities holdings, reduction in dealer         basis points
       financing needs and the dramatic decline in Treasury cash                                                   GCF Repo       Futures
                                                                        30
       balances at the Fed exacerbated the move lower.

     With reserve balances at the Fed approaching $2tr, foreign
      and domestic banks are pitching in to absorb excess               25
      reserves.

     We expect repo rates to remain in the 8-15bp range in             20
      June. But we will be closely monitoring 3 key events to
      evaluate the impact on collateral markets: (1) vote on
      MMF reform; (2) mandatory central clearing by Category 2          15
      investors; (3) large dividend payment by the GSEs to the                                                                            13.5
                                                                                                                                        12
      Treasury at June month-end.
                                                                        10                                                           11.5
     The amount of NIBTA deposits over $250K declined by just                                                                   10.5
                                                                                                                           9.5
       $70bn over the first quarter. Domestic non-interest-
       bearing accounts decreased by $97.3bn (3.8%) while                5
       interest-bearing checking and savings accounts increased         Jun-12      Sep-12 Dec-12 Mar-13               Jun-13    Sep-13
       by $121.bn (2.3%).                                             Source: Morgan Stanley Research, Bloomberg

     A vote on MMF reform is expected next Wednesday. It is
       widely anticipated that the new regulations will target        Reserves Approach $2Trillion
       prime money funds and require them to switch to floating       Reserve balances with the Fed are rapidly approaching the
       NAV.                                                           $2 trillion mark. During previous QE episodes when reserves
                                                                      increased dramatically (see Exhibit 2), most of the excess
     We outline a potential timeline for MMF reform. If the SEC
      commissioners vote on MMF reform on Wednesday it                reserves were absorbed by foreign banks as evidenced by
      could take 6 months or more for publication of final rules      the dramatic increase in foreign bank cash assets. We see
      and an implementation timeline that could last several          the same this time. Cash assets at foreign banks increased
      months to even years.                                           in January and paused in February and March, but cash
                                                                      assets at domestic banks rose in February and March. Since
                                                                      April, foreign banks are back in play, with cash assets
Market Update
                                                                      increasing by over $100bn since early April. Cash assets at
Overnight repo and Treasury bill rates stayed in the low
                                                                      domestic banks are also rising, but most of the excess
single digits all week. The dramatic decline in bill supply
                                                                      reserves are currently being absorbed by foreign banks.
continues to weigh on overnight funding rates, which
declined precipitously in May. Exhibit 1 shows monthly
average GCF repo rates and monthly average rates implied
by GCF futures market. The futures market anticipates
slightly higher average repo rates in the coming months, but
overall overnight repo rates are expected to remain in the 8-
15bp range until October. Although we expect overnight repo
rates to remain low in June, we could see some volatility as
we head into end of the second quarter. The Treasury will
receive a large dividend check for $66.4bn from the GSEs on


                                                                                                                                            21
                                                                           MORGAN STANLEY RESEARCH


                                                                           May 31, 2013
                                                                           US Interest Rate Strategist


Exhibit 2                                                                   week and maturing on June 17. This, in addition to month-
Reserves and Cash Assets at Banks                                           end coupon settlements, should put upward pressure on
                                                                            repo rates in the coming week.
 Cash Assets in $bn                                    Reserves in $bn

 1100                                                               2200    Exhibit 4
 1000                                                               2000    Treasury Cash Balances at the Fed
   900
                                                                    1800      $bn
   800
   700                                                              1600
   600                                                              1400     200
   500
                                                                    1200
   400
                                                                             150
   300                                                              1000

   200                                                              800
     Jun-10          Mar-11          Dec-11        Sep-12                    100
                 Foreign           Domestic            Reserves
Source: Morgan Stanley Research, Bloomberg                                       50

Primary Dealer Securities Holdings Decline
Although the seasonal decline in Treasury bill supply and the                    0
decline in Treasury bill rates are the primary drivers of lower                  May-12          Aug-12          Nov-12   Feb-13
repo rates, the recent decline in primary dealer holdings has
                                                                            Source: Morgan Stanley Research, Bloomberg
also contributed to the precipitous decline in repo rates.
Primary dealer securities holdings declined by $24bn this
                                                                            We expect repo rates to remain in the 8-15bp range in June.
week with most of the declines in Treasury bill holdings and
                                                                            As we have highlighted before, the availability of collateral
in Treasury coupons under 6-year maturities (see Exhibit 3).
                                                                            and the availability of dealer balance sheets will be the key
This has also resulted in a decline in primary dealer financing
                                                                            drivers of repo rates. But in June as we approach quarter
needs further contributing to the decline in repo rates.
                                                                            end, we will be closely monitoring three key events:
Primary dealer securities holdings are still high from a
historical perspective, but the decline in the availability of
                                                                            1.        SEC vote on money market fund (MMF) reform
collateral on margin should weigh on repo rates.
                                                                                      reportedly scheduled for next Wednesday

Exhibit 3
                                                                            2.        See if demand for collateral increases due to mandatory
Primary Dealer Treasury Positions                                                     clearing of Category 2 investors which goes into effect
            Security                  Net Outright Position   Change                  on June 10
       Total Government                     70064             (24,447)
         Treasury Bills                     30433              (5,172)
       Treasury Coupons                                                     3.        Large dividend payment of $66bn by the GSEs to the
            < 2 years                        36924            (7,264)                 Treasury on June 28 and its impact on quarter-end
           2 – 3 years                        2800             (788)                  funding rates
           3 – 6 years                       16548            (6,490)
           6 – 7 years                       -18451           (2,301)
                                                                            We do not expect a significant increase in demand for
          7 – 11 years                       -17999            (238)
      Greater than 11-years                  16009            (1,337)       collateral due to central clearing. In the current low rate
Source: Morgan Stanley Research, NY Fed                                     environment and with haircuts associated with posting
                                                                            collateral, it might be more advantageous to post cash
More Bills                                                                  instead of collateral to the central clearing counterparty
After a large increase in April due an influx of tax receipts,              (CCP) to meet mandated initial margin requirements.
Treasury cash balances at the Fed have declined
dramatically in May (see Exhibit 4) and are currently at                    Small Outflows from NIBTA
$14bn. As anticipated, the Treasury announced $30bn in                      The FDIC released its quarterly banking profile (QBP) this
cash management bills (CMB) to be auctioned early next                      week. As anticipated, the expiration of the unlimited FDIC


                                                                                                                                           22
                                                                               MORGAN STANLEY RESEARCH


                                                                               May 31, 2013
                                                                               US Interest Rate Strategist


insurance coverage had very little impact on deposits at non-                   switching to floating NAV would prevent financial institutions
interest-bearing transaction accounts (NIBTA). Insured                          from declaring MMF investments as “cash or cash
institutions had $2.4 trillion in domestic non-interest bearing                 equivalents” on their balance sheet. Also daily variations in
deposit accounts as of March 31, 2013, 69% or $1.67 trillion                    cash balances may prompt frequent redemptions and re-
was in transaction accounts larger than $250K FDIC                              investments resulting in short-term capital gains.
insurance limit. The aggregate amount above the $250K
coverage limit declined by just $70bn in the first quarter of                   Institutions that currently invest in stable NAV prime funds
2013 after the expiration of transaction account guarantees                     will have to address accounting and tax issues related to
(TAG) on December 31, 2012. The amount above the $250K                          switching to floating NAV or take their money elsewhere. It is
coverage limit currently stands at $1.47 trillion. A majority of                widely expected that a switch to floating NAV could trigger
the NIBTA balances continue to reside in depository                             redemptions from prime funds and inflows into government
institutions that have greater than $100bn in assets (see                       funds and other front-end investment vehicles.
Exhibit 5). Institutions with less than $100bn in assets only
hold $350bn in NIBTA deposits over $250K. Smaller                               Exhibit 6
institutions did not see much in the way of outflows either.                    Money Fund AUMs by Fund Type
                                                                                  $bn
Exhibit 5
Domestic NIBTA Accounts Larger Than $250K                                        4,000

                                                          Amount                 3,500      492
                  Number          Total                    Above     Average     3,000              400
 Asset Size          of          Assets          Total     $250K       Size

                                                                                            1,492
                                                                                                            351 328 302 290



                                                                                                    1,077
    ($bn)          Banks          ($bn)          ($bn)      ($bn)      $000      2,500                                      270 283 275 260 259




                                                                                                                     835
                                                                                                            873



                                                                                                                             785
 < $1             6,357           1,396.9         75.3        47.8   $684




                                                                                                                                      947



                                                                                                                                                        869

                                                                                                                                                                882



                                                                                                                                                                                  880
                                                                                 2,000




                                                                                                                                                                         864
                                                                                                                                              861
 $1 - $10         553             1,423.9        106.5        76.8   897
 $10 - $50        73              1,451.1        110.6        89.1   1,287
                                                                                 1,500
                                                                                            1,776

                                                                                                    1,784



                                                                                                                     1,624
 $50 - $100       17              1,326.8        153.4      136.2    2,234
                                                                                                            1,573



                                                                                                                             1,574
                                                                                 1,000




                                                                                                                                                        1,480

                                                                                                                                                                1,468
                                                                                                                                      1,434




                                                                                                                                                                         1,435

                                                                                                                                                                                  1,444
                                                                                                                                              1,400
 Over $100        19              8,825.9      1,232.9    1,122.1    2,783
                                                                                   500
 Total            7,019          14,424.6      1,678.6    1,472.0    2,031
Source: FDIC Quarterly Banking Profile - March 31, 2013                               0




                                                                                                                                                                         Apr-13

                                                                                                                                                                                  May-13
                                                                                            YE-08

                                                                                                    YE-09



                                                                                                                     YE-10



                                                                                                                                      YE-11



                                                                                                                                                        YE-12

                                                                                                                                                                Mar-13
                                                                                                            10-Jun



                                                                                                                             11-Jun



                                                                                                                                              12-Jun
Assets of FDIC-insured depository institutions remained
stable over the last quarter. While total deposits remained                          Prime Funds              Government Funds                         Tax-Exempt Funds
relatively unchanged, domestic deposits decreased by
                                                                                Source: Morgan Stanley Research, iMoneyNet
$20.5bn while foreign deposits increased by $22.3bn. Money
also moved from domestic non-interest-bearing accounts to
                                                                                SEC commissioner Aguilar, who has expressed concern
interest-bearing accounts in Q1-2013. Domestic non-interest-
                                                                                about a switch to floating NAV in the past, might now support
bearing accounts decreased by $97.3bn (3.8%) while
                                                                                such a move. Although the current draft proposals that are
interest-bearing checking and savings accounts increased by
                                                                                scheduled to be voted on next week are expected to win the
$121.bn (2.3%). Even though the expiration of unlimited
                                                                                support of the five SEC commissioners, the process for
FDIC insurance on NIBTA accounts was well publicized,
                                                                                implementing the additional reforms is likely to be lengthy.
outflows from these accounts were much lower than
anticipated.
                                                                                MMF Reform Implementation Timeline
                                                                                According to media reports, the SEC commissioners are
SEC to Vote on MMF Reform Next Week
                                                                                scheduled to vote on additional MMF reforms next
A vote on MMF reform by SEC commissioners could come
                                                                                Wednesday. The current proposals will probably not be
as early as next week 11 . It is widely anticipated that the new
                                                                                voted on if SEC Chairman White does not think there is
regulations will target prime money funds (see Exhibit 6),
                                                                                majority support for the new proposals from the five SEC
which might be required to switch to floating net asset value
                                                                                commissioners. This is what happened last August when
(NAV). The proposals may target just institutional prime
                                                                                Chairman Shapiro decided not to bring the proposals to a
money funds and not retail funds, which currently represent
                                                                                vote and additional studies were commissioned to
37% of the MMF assets under management (AUM).
                                                                                investigate the workings of cash management as
Comment letters from industry participants suggest that
                                                                                recommended by Commissioner Aguilar.
11
  See Wall Street Journal SEC to Vote Next Week on Money-Market Fund
Rules, May 29, 2013


                                                                                                                                                                                           23
                                                                      MORGAN STANLEY RESEARCH


                                                                      May 31, 2013
                                                                      US Interest Rate Strategist


Once the chairman determines there are sufficient votes for            and regulations. For instance, if the new rules were to only
the current proposals, a public hearing is scheduled where             affect institutional funds and not retail funds, that would
the proposals are widely discussed and the details of the              present many operational issues and could be costly and
proposals made available for review and then voted on by               time consuming to implement for fund administrators. The
the commissioners. If there is a majority support for the              compliance timeline outlined in the final rule should take
proposals, the SEC then issues a Notice of Proposed                    such issues into account.
Rulemaking (NPRM). The NPRM is published in the Federal
Register and typically industry participants are given 60 days         What Happened Last Time?
to submit comments and an additional 30 days for reply                 A quick walk down memory lane takes us to 2008 when the
comments. But in this instance the SEC gets to decide on               SEC amended Rule 2a-7 following the Lehman bankruptcy
how long the comment period should be.                                 when the Reserve Fund broke the buck in September 2008.
                                                                       The SEC commissioners voted to propose changes to Rule
After the close of the comment period, the SEC could take              2a-7 on June 30, 2009. The NPRM was published in the
several months to review the comments before adopting                  Federal Register on July 8, 2009, and the comment period
changes to existing rules or proposing new rules. The SEC              lasted for 60 days. After the end of the comment period in
has to carefully evaluate the efficacy of the new rules and            September 2009, the SEC spent the next few months
suggestions received from the comment letters. Once the                reviewing the comments and coming up with a final rule,
draft rules are in place, the SEC commissioners have to vote           which was approved on January 27, 2010. The new rules
on the final rule in a public forum. The final rule details all the    were gradually phased in, allowing market participants time
new regulations and timeline for compliance. The final rule is         to comply with the new rules. Depending on the rule change
typically designed to give market participants ample time to           market participants had anywhere from two months to two
build the required infrastructure to comply with the new rules         years in some instances to comply.




                                                                                                                                      24
                                                                                               MORGAN STANLEY RESEARCH


                                                                                               May 31, 2013
                                                                                               US Interest Rate Strategist



US Interest Rate Derivatives: Swaps
Position Wider
Mikhail Levin (212) 761-8556                                                                   Clearing Mandates and Back-end Spreads
                                                                                               Going forward, we see several factors continuing to drive
        Following the large move in rates, we look at this week’s
                                                                                               swap spreads. On the back end of the spread curve, Dodd-
         move in spreads and discuss the short-term drivers of
         spreads going forward.                                                                Frank regulation continues to be a factor. Beginning on June
                                                                                               10, Dodd-Frank clearing mandates will go into effect for
        Mandated swap clearing for many financial institutions                                Category 2 institutions (financial entities less active than those
         begins on June 10. While we do not anticipate a major
                                                                                               covered by the original Category 1 clearing mandate). While
         market disruption, as investors realize the additional
                                                                                               there has been considerable market discussion about
         trading costs and seek out alternative sources of duration,
                                                                                               investors being unprepared for this mandate, we do not
         we may see a further widening in back-end spreads.
                                                                                               anticipate any significant disruption in swap trading. Although
        Belly spreads will continue to be driven by mortgage                                  some investors may be unprepared for clearing, we believe
         hedging activity. Given the asymmetric nature of mortgage                             them generally to be investors who trade swaps fairly
         hedging, we believe belly spreads are biased to widen.
                                                                                               infrequently and in limited size, and therefore have a limited
        The PCA weighted ED1/ED3/ED5 butterfly has reached a                                  market impact.
         local extreme. We recommend going long the belly of the
         fly to fade this extreme level.                                                       While we do not see any disruption in the market as likely, the
                                                                                               increased cost of swap trading for Category 2 clients after the
This week’s massive rate move brought with it a significant                                    clearing mandate goes into effect is likely to increase trading
widening in spreads, especially in the front end and belly of                                  costs for these investors. To the extent they are able to switch
the curve (Exhibit 1). As 10-year rates sold off by 15bp on                                    out of swaps into cheaper alternatives such as Treasury
Tuesday, we saw a large spread widening as a result of                                         futures, we see a possibility for investors to move in this
mortgage convexity hedging and corporate rate locking                                          direction. Although back-end spreads have already widened in
activity. While 30-year spreads ended the week where they                                      anticipation of this move, we believe there could be a further
started, spreads from the 10-year point inward widened by                                      widening in spreads as this clearing mandate kicks in, and
2.75 to 4.00bp.                                                                                traditional receivers of back-end swaps seek alternative
                                                                                               sources of duration.

Exhibit 1
                                                                                               Convexity Hedging and Belly Spreads
One Week Change in Swap Spreads*
                                                                                               Looking to belly spreads, we believe mortgage convexity
  1-Week Move in Spreads (bp)                                                                  hedging will continue to be a major driver. Exhibit 2 displays
 5                                                                                             the total duration profile of Mortgage Servicing Rights (MSRs).
                                                                                               MSRs tend to be the most actively hedged securities in the
                                                                                               MBS universe. The selloff in rates over the past few weeks
 4
                                                                                               has made the MSR universe significantly more negatively
                                                                                               convex, causing mortgage servicer hedging to have a larger
 3                                                                                             impact on rates and spreads.


 2                                                                                             Given the impact of mortgage servicers, we expect belly
                                                                                               spreads to trade directionally with rates. If rates sell off, we
                                                                                               would expect servicers to hedge their increased duration, with
 1                                                                                             some of this hedging likely to take the form of paying on
                                                                                               swaps, leading to wider spreads. If rates were to fall, we
 0                                                                                             would likely see a reversal of at least part of this hedging, and
            2Y           3Y            5Y             7Y           10Y           30Y           with it the recent widening in spreads.


*From May 22, 2013 to May 29, 2013. Spread is relatively to the OTR treasury at the start of
the period.
Source: Morgan Stanley Research




                                                                                                                                                              25
                                                                  MORGAN STANLEY RESEARCH

                                                                  May 31, 2013
                                                                  US Interest Rate Strategist




Exhibit 2                                                         Exhibit 3 displays the kink in Eurodollar curve slope around
Duration Profile of the MSR Universe in 10y                       the EDZ3 contract. This can equivalently be viewed as excess
Equivalents ($bn)                                                 rolldown present at the point.

     0                                                            Exhibit 3
   -10                                                            Eurodollar Curve Rolldown
   -20                                                              bp              Eurodollars Calendar Spreads
   -30                                                             20
   -40                                                             18
                                                                   16
   -50
                                                                   14
   -60                                                             12
   -70                                                             10
   -80                                                              8
                                                                    6
   -90
                                                                    4
 -100                                                               2
            -50    -25       0    25   50   75   100 125 150        0
                                                                         0                          5            10            15
As of May 28, 2013
Source: Morgan Stanley Research
                                                                                               ED IMM Contract
                                                                                    Current                      1 Month Ago
However, it is important to note that even if we were to see a
                                                                  *As of May 30, 2013
reversal of this week’s move in rates, spreads would not          Source: Morgan Stanley Research
necessarily fall back to their mid-May levels. In practice,
mortgage hedgers will often hedge based on the range they         We recommend taking advantage of this opportunity in the
believe we are in. Even if rates were to fall back, if hedgers    form of a PCA Eurodollar butterfly. We recommend investors
believe we have entered a new trading regime, they may not        enter a PCA Weighted EDN3/EDZ3/EDM4 fly:
adjust their hedges as quickly.
                                                                             Short 1,120 contracts EDN3

Therefore, the risk to spreads is somewhat asymmetric. A rate                Long 1,000 contracts EDZ3
rally may not lead to a full reversal of the spread widening,
                                                                             Short 310 contracts EDM4
while a further selloff may lead to additional hedging, leading
driving spreads wider still.                                      The trade is weighted based on a 1-year PCA using changes
                                                                  in interpolated Eurodollar contracts in order to avoid the
One last element to note on mortgage hedging activity: It need    impact of rolls. We choose to use the July contract rather than
not occur only in swaps space. Hedging in a selloff can also      the June contract because the June contract expires in two
be done by selling mortgages or shorting Treasuries. Based        weeks, and the July contract costs us only marginally more in
on this week’s price action in mortgages, we believe that         rolldown. Investors can position for a reversion of the extreme
much of the hedging was done by selling mortgages.                fly level, while earning a flat to slightly positive 3-month
                                                                  rolldown that is approximately 0.5bp.
Relative Value in Front-end Eurodollars
The recent selloff in rates has presented attractive              Exhibit 4 displays the PCA fly’s relationship to outright rates.
opportunities on the front end of the Eurodollar curve both in    The fly has had very little exposure to outright rates recently,
terms of rolldown and relative value. The entire Eurodollar       and the longer-term history actually suggests a negative
curve has steepened considerably during this recent selloff,      correlation with rates. While we regress the fly against ED5 in
with the very front end showing the greatest amount of            the exhibit, using the other legs or using the 2-year swap does
steepening.                                                       not materially change the relationship.




                                                                                                                               26
                                                                                     MORGAN STANLEY RESEARCH

                                                                                     May 31, 2013
                                                                                     US Interest Rate Strategist




Exhibit 4                                                                            Given the low recent correlation with rates and the current
Correlation between Eurodollar Fly and Rates*                                        extreme level, we see an opportunity to fade this extreme
                                                                                     level.
  PCA ED1/ED3/ED5 (bp)
   -5                                                                                Investors can also enter a 50:50 weighted EDN3/EDZ3/EDM4
                                                                   3M History        fly to play for a reversion in the curve and earn 1bp of 3-month
                                                                 y = 0.04x - 13.03   rolldown. However, we prefer the PCA version as the 50:50
 -10                                                                  R2 = 8%
                                                                                     version is correlated with front-end rates and does not appear
                                                                                     extreme relative to its recent history.
 -15
                                                                                     While the PCA trade has not been correlated with rates, as
                                                                                     with other PCA trades, there is a risk that we could see a
 -20            1Y History:                                                          regime shift in which the PCA weights change and the fly
              y = -0.28x - 1.28                                                      becomes more directional with rates. With the recent increase
                  R2 = 47%                                                           in front-end volatility, this becomes a more likely scenario.
 -25                                                                                 However, given the fly’s recent range, we are comfortable
        30                 40                 50                60             70    fading the move unless the fly level becomes significantly
                                           ED5 (bp)                                  more extreme.
            1Y History                     3M History                Current

*Using interpolated Eurodollar contracts
Source: Morgan Stanley Research


However, during this week’s rates move, the PCA weighted fly
reached an extreme level (Exhibit 5). The fly is approximately
1.5bp above its year-to-date average.

Exhibit 5
YTD History of Eurodollar PCA Fly
  PCA ED1/ED3/ED5 (bp)
   -9


 -10


 -11


 -12


 -13


 -14
   Jan 13           Feb 13          Mar 13          Apr 13      May 13


* As of May 30, 2013, using interpolated Eurodollar contracts
Source: Morgan Stanley Research




                                                                                                                                                   27
                                                                                        MORGAN STANLEY RESEARCH

                                                                                        May 31, 2013
                                                                                        US Interest Rate Strategist




Swap Data Update                                                                        Exhibit 7

Here is this week’s breakdown of swap trades reported to the                            SDR Swap Volume History*
DTCC’s swap data repository:                                                              Average Daily Volume by Week ($bn)

Exhibit 6                                                                                120
Weekly SDR Swap Volume*
                                                                                         110
Notional
$bn             1Y       2Y      3Y      5Y      7Y    10Y      20Y     30Y    Total     100
                1.8    26.2     30.5   111.0    51.6   84.4     10.3    11.2
Spot                                                                           326.9
                                                                                           90
3m              1.2      0.7     0.6     9.7     6.4    2.3      0.0     0.0    21.0
6m              0.0      0.1     0.5     1.0     0.9    1.4      0.4     0.2      4.5      80
1y              1.7      1.1     1.0     0.7     0.1    0.9      0.0     0.8      6.4
                                                                                           70
2y              0.9      0.7     0.2     0.2     0.1    0.2      0.1     0.0      2.3
3y              0.7      3.3     0.1     0.0     0.0    0.3      0.0     0.1      4.4      60
5y              0.5      1.4     0.8     1.7     0.0    0.5      0.2     0.4      5.5
10y             0.0      1.4     0.0     0.6     0.0    0.1      0.0     0.1      2.2
                                                                                           50
Total Non-                                                                                 40
Spot            4.9      8.7     3.1    14.0     7.5    5.8      0.7     1.5    46.2
                                                                                            Jan-11          Feb-11        Mar-11          Apr-11        May-11
 Total           6.7      34.9   33.6 125.0      59.1 90.1         11.1   12.7 373.2
*Volumes include USD 3m Libor Interest Rate swaps traded between May 24, 2013 and May
30, 2013 and reported to the DTCC’s SDR. Capped notionals are estimated.
                                                                                                                      Week Ending
Source: Morgan Stanley Research, DTCC
                                                                                        *Volumes include USD 3m Libor Interest Rate swaps reported to the DTCC’s SDR.
                                                                                        Source: Morgan Stanley Research, DTCC




                                                                                                                                                                        28
                                                                                                        MORGAN STANLEY RESEARCH


                                                                                                        May 31, 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 Spread                    1y       0.82       1.5          872             395           7.8      5y/10y Swap Curve               1y       0.92        3.2        1763            1714             7.9
Widener                     3m        0.93       1.1          805             331           4.6      Steepener                      3m        0.82        1.2        1281            2658             4.4
Long 20y on                  1y      -0.79       -2.4         872             406           7.3                                      1y       1.00        0.7          437            342             7.7
                                                                                                     Pay 5y Forward 5y
10y/20y/30y
                                                                                                     Swap                           3m        0.97        0.6          553            836             3.7
Spread Fly                  3m        0.02       0.1          612             480           1.7
                                                                                                     2Y Forward 2y/7y                1y       0.84        2.9        2226            2606             7.6
3Y Spread                    1y       0.77       1.5          711            434            6.3      Swap Curve
Widener                     3m        0.89       1.2          692            231            3.1      Steepener                      3m        0.79        1.1        1468            3030             4.7
Pay 10y Forward              1y       0.71       0.1          628            452            5.4      3M Forward 5y/10y               1y       0.89        3.4        1897            2047             7.6
10y Swap                    3m       -0.53      -0.1          618           1084            3.1      Swap Curve
                                                                                                     Steepener                      3m        0.79        1.2        1303            2886             4.4
Pay 10y Forward              1y       0.71       0.1          633            456            5.4
30y Swap                                                                                             5y/7y Swap Curve                1y       0.95        5.7        1359            1229             7.5
                            3m       -0.54      -0.1          615           1096            3.1
                                                                                                     Steepener                      3m        0.87        2.9        1168            2127             4.2
2-Year Receive Fixed
                                                                                                     10-Year Receive Fixed
                             1y       0.87       1.4          462              -72          2.8
Long 2Y UST                                                                                                                          1y       0.97        2.7        1686             496             7.9
                            3m        0.56       1.5          527               40          1.0
                                                                                                     Long 3Y UST                    3m        0.60        2.4        1415           -1401             0.0
                                                                                                                                     1y       0.99        1.3          654            477             6.6
                                                                                                     Receive 5Y Swap                3m        0.78        1.3          607           -537             0.1
                                                                                                                                     1y       1.00        1.1          313            247             6.6
                                                                                                     Receive 7Y Swap                3m        0.95        1.3          471            338             1.7
                                                                                                                                     1y       0.88        5.6        3457              81              6.4
                                                                                                     Long 2Y UST                    3m        0.03        0.2        -852           -4382             -3.4
                                                                                                     Receive 3m Forward              1y       0.99        1.2          528            446             6.2
                                                                                                     5y Swap                        3m        0.82        1.3          570           -223             0.4
5-Year Pay Fixed
                                                                                                     30-Year Pay Fixed
5y/10y Swap                  1y       0.86       2.2         1763           1714            7.9
Curve Steepener                                                                                      Pay 10y Forward 5y              1y       1.00        0.8          379            266             8.6
                            3m        0.27       0.2         1281           2658            4.4
                                                                                                     Swap                           3m        1.00        0.7          382            572             4.4
5y/7y Swap Curve             1y       0.90       4.0         1490           1359            7.7
Steepener                                                                                            5y/10y Swap Curve               1y       0.97        3.5        1268            1152             8.1
                            3m        0.36       0.7         1269           2435            4.3
2Y Forward 2y/7y                                                                                     Steepener                      3m        0.96        2.2         944            1771             4.1
                             1y       0.75       1.9         2050            2334           7.7
Swap Curve                                                                                           Pay 10y Forward 7y              1y       1.00        0.8         414             311             8.1
Steepener                   3m        0.23       0.2         1307           2762            4.5      Swap                           3m        0.99        0.7         411             642             4.5
3M Forward                   1y       0.82       2.3         1846           1951            7.7      3M Forward 5y/10y               1y       0.95        3.8        1430            1506             7.8
5y/10y Swap                                                                                          Swap Curve
Curve Steepener             3m        0.23       0.2         1277           2743            4.4      Steepener                      3m        0.95        2.2          993           2121             4.2
ED12/ED16 Curve              1y       0.95       1.8         1042            999            7.7      2Y Forward 2y/7y                1y       0.90        3.3        1820            2125             7.6
Steepener                   3m        0.66       0.9         1131           1564            3.8      Swap Curve
                                                                                                     Steepener                      3m        0.94        2.0        1285            2399             4.7
5-Year Receive Fixed
                                                                                                     30-Year Receive Fixed
                             1y       0.99       2.0          784              29           6.0
Long 3Y UST                                                                                                                          1y       0.92        2.7        2251             927             6.7
                            3m        0.79       1.9          671            -607           0.1
                                                                                                     Long 3Y UST                    3m        0.40        2.5        2018           -1850             0.1
                             1y       0.90       4.3         2160            -257           5.2
Long 2Y UST                                                                                                                          1y       0.81        5.5        3923             452              6.2
                            3m        0.37       1.4         -130          -2537           -3.1
                                                                                                     Long 2Y UST                    3m       -0.16       -1.4       -1539           -5414             -3.0
Receive 1m                   1y       0.99       1.3          220             208           3.2
Forward 2y Swap                                                                                                                      1y       0.95        1.3        1238             939             5.6
                            3m        0.95       1.2           69            -368          -1.0
                                                                                                     Receive 5Y Swap                3m        0.51        1.3        1174           -1042             0.1
                             1y       0.97       1.8          409            105            2.6
Receive 3Y Swap                                                                                      Receive 3m Forward              1y       0.95        1.2        1114             915             5.4
                            3m        0.82       1.2         -147          -1338           -2.8
                                                                                                     5y Swap                        3m        0.58        1.3        1237            -458             0.4
ED4/ED6 Curve                1y       0.94       5.4         -135            571            1.5
Flattener                                                                                                                            1y       0.97        1.1         911             748             5.4
                            3m        0.47       2.1         -806          -1651           -3.0
                                                                                                     Receive 7Y Swap                3m        0.79        1.6        1401            1025             1.7
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 30,
2013. Source: Morgan Stanley Research




                                                                                                                                                                                                  29
                                                                             MORGAN STANLEY RESEARCH


                                                                             May 31, 2013
                                                                             US Interest Rate Strategist



Special Topic
The Revival of Volatility
Matthew Hornbach (212) 761-1837                                               volatilities have been well correlated with term premiums.
                                                                              Exhibit 2 graphs 10-year term premiums against 3m10y
Ankur Shah (212) 761-1909
                                                                              implied swaption volatilities. Exhibit 3 graphs the in-sample
                                                                              regression differential over time. Since September 2012,
           The recent spike in rates has driven realized and implied
            volatilities higher, reversing the divergence between
                                                                              when the Fed announced the MBS component of QE∞,
            volatility and term premiums. We highlighted the risk to          implied vol has fallen relative to term premiums, appearing
            higher volatility if 10-year swap rates crossed 2.2%, and         25 normal bp cheap. Recent market moves have partially
            we expect realized volatility to persist at these rate levels     reversed the divergence, closing the gap to 15 normal bp.
            from revived mortgage convexity hedging. Finally, using
            our tapering framework we calculate fair-value Treasury           Exhibit 2
            yields for different scenarios.
                                                                              3m10y Implied Vol vs. 10-Year Term Premiums*
                                                                                   Vol (normal bp)                                                    %
Volatility Comes Back…                                                         240                                                                    4
                                                                                                  3m10y Implied Vol (LHS)
Since May 2nd, 10-year swap rates have risen by over 50bp,
initiated by the stronger-than-expected revisions in the April                                    10-Year Term Premium (RHS)

NFP report and escalated by FOMC Chairman Bernanke’s                           200                                                                    3
comments to the Joint Economic Committee. The spike in
rates has driven implied volatility off its lows, with 3m10y vols              160                                                                    2
rising over 27 normal bp, as shown in Exhibit 1.


Exhibit 1
                                                                               120                                                                    1
                                                                nd
Change in Implied Volatilities Since May 2
  Vol Change (normal bp)                                                           80                                                                 0

 35                                        3m        6m    1y   2y      5y
                                                                                   40                                                               -1
 30
                                                                                    Jan-97         Jan-01         Jan-05        Jan-09        Jan-13
 25
                                                                              * Per our Dynamic Term Structure Model (DTSM)
                                                                              Source: Morgan Stanley Research
 20

 15                                                                           …But Is It Here to Stay?
                                                                              Although realized volatility has increased, will it persist? In
 10                                                                           our opinion, the answer is yes, relative to term premiums. We
   5                                                                          have noted in the past 12 that 10-year swap rates would need
                                                                              to break above 2.2% for implied volatility to rally significantly.
   0                                                                          Exhibit 4 shows how the 2.2% threshold for 10-year swap
                                                                              rates has led to higher implied volatility historically – which
  -5
                                                                              we partially attribute to increased MBS convexity hedging
                 2y                 5y               10y          30y         sensitivity. Exhibit 5 displays the duration profile of
                               nd               th
* Changes calculated from May 2 , 2013 to May 29 , 2013.
                                                                              Mortgage Servicing Rights (MSR) in 10-year Treasury
Source: Morgan Stanley Research, Bloomberg                                    equivalents. MSR hedgers are among the most active
                                                                              hedgers within the MBS community. As rates rise (fall), the
The recent moves have narrowed the residual between                           duration profile of MSR hedgers increases (decreases). At
volatility and rates – or more accurately, volatility and term                lower rate levels, the change in duration was minimal,
premiums. We prefer to compare vol against term premiums,                     resulting in low convexity hedging needs. However, at
as opposed to rates, as we believe term premiums are a
more fundamental driver. Over the past 15 years implied                       12
                                                                                   See US Interest Rate Strategist: High Enough? from May 3rd, 2013


                                                                                                                                                          30
                                                                                        MORGAN STANLEY RESEARCH


                                                                                        May 31, 2013
                                                                                        US Interest Rate Strategist


current and higher rate levels, the duration profile changes                             Exhibit 5
more significantly – at nearly six times the pace from before.                           MSR Duration over Parallel Swap Rate Scenarios
We estimate the MSR duration profile to extend by $12bn
                                                                                          MSR Duration ($bn 10-Year Treasury Equivalents)
10-year Treasury equivalents in a 25bp selloff.
                                                                                            0
                                                                                            -10
Exhibit 3
3m10y Implied Vol Differential Based Upon Term                                              -20
Premium Regression*                                                                         -30

  Actual - Estimated Implied Vol (normal bp)                                                -40
                                                                                            -50
  40
                                          Im plied Vol is cheap                             -60
  30
                                                                                            -70
  20                                                                                        -80

  10                                                                                        -90
                                                                                          -100
    0                                                                                                -50    -25    0    25     50  75 100 125 150
 -10                                                                                                          Parallel Move in Swap Curve (bp)
                                                               Im plied vols
                                                               have partially            Source: Morgan Stanley Research, Yieldbook
 -20
                                                               reverted back
 -30                                                           to fair value             Exhibit 6 displays the total duration profile of the MBS
               Im plied Vol is rich                               ti   t                 universe, removing the MBS assets held by the Fed (which
 -40                                                                                     doesn’t hedge its convexity). Under the last 25bp selloff,
  May-10                    May-11                  May-12                   May-13      agency MBS would have extended duration by $100bn 10-
                                                                                         year Treasury equivalents. Using a 20% rule of thumb as the
* Term Premiums are calculated using our DTSM. Differential calculated using a linear
regression calibrated from 1997 to current.                                              hedging percentage results in selling flows of $20bn 10-year
Source: Morgan Stanley Research
                                                                                         Treasuries.

Exhibit 4
                                                                                         Exhibit 6
3-Year History of 3m10y Implied Swaption Vol vs.
                                                                                         Agency MBS Duration over Parallel Swap Rate Scenarios
10-Year Swap Rate
                                                                                          MBS Duration ($bn 10-Year Treasury Equivalents)
  3m10y Implied Vol (normal bp)
                                                                                          2,000
 140
                                                                                          1,800
                                                                                          1,600
 120
                                                                                          1,400
                                                                                          1,200
 100
                                                                                          1,000
                                                                                             800
   80
                                                                                             600
                                             Im plied vols have
                                             richened around 2.2%                            400
   60
                                                                                             200
                                                                                                0
   40
                                                                                                      -50     -25     0   25 50 75 100 125 150
     1.00                1.75       2.50       3.25                              4.00
                                                                                                             Parallel Move in Swap Curve (bp)
                           10-Year Swap Rate (%)
                                                                                         Source: Morgan Stanley Research, Yieldbook
Source: Morgan Stanley Research

                                                                                         The main risk to implied vol – relative to term premium – is
                                                                                         Fed action. While the Fed clearly wants markets to react

                                                                                                                                                        31
                                                                                 MORGAN STANLEY RESEARCH


                                                                                 May 31, 2013
                                                                                 US Interest Rate Strategist


more effectively to changing economic data – as evidenced                         final column shows the ‘fair value’ level for 10-year Treasury
by the introduction of the Evans Rule – this need not lead                        yields under each of these tapering assumptions. For
to higher volatility. We have argued in past research that                        instance, if the Fed begins to taper purchases in July, we
by linking policy to data, the Fed has tolerated short-term                       believe 10-year Treasury yields should lie between 2.25-
volatility while depressing long-term volatility. The argument                    2.30%. We believe the Fed will most likely begin tapering in
is as follows:                                                                    the December meeting, with September being the first
                                                                                  reasonable opportunity to taper.
    Evans Rule framework, economic targets and increased
     transparency allow markets to better translate changes                       Exhibit 7
     in economic data to changes in Fed policy                                    Treasury Yields Expected Changes and Levels
                                                                                  Under Tapering Scenarios*
    Markets can then re-price asset classes to reflect                                                           5-Year        10-Year       30-Year
     changes in data                                                                                                Yield         Yield          Yield     10-Year Yield
                                                                                                                 Change        Change         Change               Range
    Changes to Fed policy are better anticipated and have                        Taper Begins…                      (bp)           (bp)          (bp)                 (%)

     reduced impact upon announcement                                             In June                              25            26             27         2.40-2.45
                                                                                  In July                              14            14             15         2.25-2.30
                                                                                  In September                          0             0              0         2.10-2.15
Historically, a goal of Fed officials has been reduced                            In October**                        -11           -12            -12         2.00-2.05
macroeconomic volatility. The following quote from then-                          In December                         -26           -28            -28         1.85-1.95
Governor Bernanke in 2004 13 implicitly associates better                         No buying after June                 62            62             61         2.75-2.80
                                                                                  Source: Morgan Stanley Research, * Assumes tapering schedule implied by the New York
monetary policy with reduced macroeconomic volatility:                            Fed Primary Dealer Survey from March, ** Assumes market was priced for the first taper in
                                                                                  October when the NY Fed Primary Dealer Survey submissions were due.

I am not convinced that the decline in macroeconomic
                                                                                  Conclusion
volatility of the past two decades was primarily the result of
good luck, as some have argued, though I am sure good luck                        The sharp rise in rates has driven realized and implied
had its part to play as well. In the remainder of my remarks, I                   volatilities substantially higher. As a result, the divergence
will provide some support for the "improved-monetary-policy"                      between term premiums and implied volatilities – which have
explanation for the Great Moderation.                                             been historically well correlated – has narrowed. The return
                                                                                  of mortgage convexity hedging may continue pushing vol
We do not believe that the Fed’s intent is to increase                            higher relative to term premium, and drive vol back into
volatility, but rather decrease it relative to where it may                       historically fairer levels. However, the move in vol must be
have risen if the market expected a different outcome. When                       taken in context with rates. If yields fall back to lower levels,
the Fed clarified their perspective, via Chairman Bernanke’s                      implied vols will fall as well – but to higher levels than
comments, the subsequent price action raised volatility.                          previously occupied.

Impact on Yields
The recent Fedspeak and increased realized volatility have
recalibrated expectations for Treasury yields. Last week 14 we
updated our framework for assessing the impact of tapering
on yields. Specifically, we took the Fed’s Primary Dealer
Survey conducted in March as a baseline. We used the
March survey because we think sentiment then is closer to
current market sentiment. Using the baseline tapering
estimates provided in the survey, we then used our Dynamic
Term Structure Model (DTSM) and estimated the impact of
tapering upon yields using our prior framework 15 .

Exhibit 7 shows our estimated impact on 5-, 10-, and 30-
year Treasury yields under various tapering scenarios. The

13
   See Governor Bernanke’s Remarks, February 20th, 2004
14
   See US Interest Rate Strategy Insight: Don’t Fear the Taper, May 24th, 2013
15
   See US Fixed Income Strategy Insight: To Taper or Not to Taper…, March
1st 2013


                                                                                                                                                                        32
                                                                       MORGAN STANLEY RESEARCH


                                                                       May 31, 2013
                                                                       US Interest Rate Strategist



US Interest Rate Derivatives: Volatility
Running with the Bulls
Ankur Shah (212) 761-1909                                               premium to 3m30y vols – a signal of the market’s concerns
                                                                        about potential bear-flattening due to increasing rate
      Vol continued its dramatic rise this week, as Tuesday’s          expectations.
       price action spurred realized volatility. We find that
       volatility has risen not only outright, but also relative to
                                                                        Exhibit 1
       rates and term premium, converging back to historically
       fair value. We expect volatility to continue to rise relative
                                                                        Change in Normalized Vols*
       to term premium.                                                     Vol Change (normal bp)
      The choppy price action spurred trading activity across              20
       rates markets. Outright buying of vol, conditional curve
       and invoice trades, unwinds of older short gamma
       positions, and mortgage convexity hedging helped push
                                                                            15
       gamma higher and reshape the vol surface. Intermediate
       tails were most affected by convexity hedging concerns,
       as well as by a re-evaluation of curve dynamics going
       forward.
                                                                            10

      We like buying 1y forward 1y30y vol to go long vega. The
       FVA is a cleaner way to purchase vol without incurring               5
       theta decay. Current entry levels look very attractive
       against history, and the trade carries positively over a year
       by 51bp. We highlight how 30-year tails are optimal
                                                                            0
       across the surface, and the attractive risk-adjusted return.
                                                                                        2y                  5y                  10y   30y

Vol continued to ascend this week, both in absolute terms                           3m       6m       1y       2y      5y
and relative to rates (see Exhibit 1). We examine the rise in           * Changes calculated from May 24th, 2013 to May 31st, 2013.
volatility in this publication’s Special Topic report, and find         Source: Morgan Stanley Research, Bloomberg

the increase in yields has reignited mortgage convexity
hedging. Volatility will likely continue to richen against rates –      As detailed in this week’s Special Topic, we believe volatility
or more accurately, richen against term premium – back to               can continue to rise – both outright and relative to term
historically fairer value.                                              premiums. Recent price action has choppy, due to mortgage
                                                                        convexity hedging flows, month-end extensions, economic
Trading volumes have skyrocketed as markets re-hedge and                data, and positioning. We expect conditions to continue until
adjust for the break. The CME Group reported the highest                the Non-farm Payroll Report next week, and could potentially
daily volume record for May 29 of 26.9m contracts, led by               last after. In such an environment, we feel it prudent to
rates volumes of 19.4m contracts. In vol, we have seen                  position long volatility. Investors who wish to position long
interest in outright long constructions, expiry curve unwinds,          volatility, we recommend buying 1y1y30y forward volatility
conditional invoice spread trades, conditional curve trades,            agreements.
and mortgage convexity hedging via intermediate payors.
                                                                        Trade Idea: Buy 1y1y30y FVA
Generally, the vol surface has flattened (short-dated expiries                  Buy a 2y30y straddle, where the strike is set in 1 year
have richened to longer-dated expiries), and intermediate                       Pay 1250bp upfront (equivalent to 81.5 normal bp vol)
tails have richened substantially to longer-dated tails. The bid
to gamma is unsurprising, as gamma is the most volatile part                    Reference 1y30y 1301bp, 2y30y 1774bp
of the surface and trades more closely to realized vol. The                     Hold for 1 year
bid to intermediate tails also makes sense given the relative
                                                                        A Forward Vol Agreement (FVA) allows investors to take a
outperformance of intermediate realized vol, as well as the
                                                                        pure view on the change in volatility, without the complication
increased bid from mortgage hedgers that focus in that
                                                                        of delta-hedging. The 1y1y30y FVA is a contract in which the
section of the surface. 3m10y implied vol now trades at a
                                                                        buyer commits to purchasing a 1y30y straddle in 1 year, but

                                                                                                                                            33
                                                                     MORGAN STANLEY RESEARCH


                                                                     May 31, 2013
                                                                     US Interest Rate Strategist


locks the price of the straddle in today. The strike of the           corresponding additional return – makes 30y tails look
straddle is set to the observed 1y30y ATMF in 1 year. Since           relatively attractive on a risk-adjusted basis.
the strike is not set immediately, the option does not have
direct exposure to the movement of interest rates over the            The primary risk to the trade is that volatility falls. While the
next year, mitigating the need for delta hedging. The PnL of          theoretical max loss is 1250bp, this assumes volatility falls to
the trade is therefore dictated by the premium paid today             zero – a highly unlikely event. As stated earlier, we believe a
(1250bp) versus the value of a 1y30y straddle in 1 year.              47bp max loss to be a much more likely scenario.

Exhibit 2 graphs the historical premium of 1y30y straddles            SDR Data Update
against the entry level on the FVA. With volatility rising off its    Swaption data continues to flow into the DTCC’s swap data
lows, the 3-year historical max loss on the trade is 47bp. On         repository. Here is this week’s data:
the other hand, if in 1 year volatility rises back to more
historically observed levels, the potential max profit is 747bp.      Exhibit 3
We do not expect volatility to rise so quickly, but would target      Weekly SDR Swaption Volume*
a 150bp profit, based upon our estimate that 1y10y vol could          Notional
rise 10 normal bp if volatility and term premiums re-converge.        $mm            1Y        2Y        3Y      5Y       7Y      10Y      30Y     Total
                                                                      1m               0      400     2,279    3,814     350     8,401     890   16,134
                                                                      3m           2,102        0     3,448    7,065    1,211    6,702     504   21,032
Exhibit 2
                                                                      6m            450         0       477    1,947       0     7,178     881   10,933
1y30y Straddle Premium vs. FVA Entry Level                            1y           1,600    1,090         0    4,372     470     6,815     233   14,580
                                                                      2y            800       879       850     820        0     3,376     479    7,204
  1y30y Straddle Premium (bp upfront)
                                                                      3y           1,600        0         0     850      200     2,350     122    5,122
 2000                                                                 5y               0      400        16    1,035       0     1,108     991    3,550
                                                                      10y              0        0         0     125        0      941      100    1,166
                                                                       Total        6,552     2,769     7,070 20,028     2,231 36,871       4,200 79,721
                                                                      *Volumes include USD European swaptions traded between May 24th 2013 to May 30th
                                                                      2013.
 1800                                                                 Source: Morgan Stanley Research, DTCC




 1600



 1400



 1200
   May-10                  May-11      May-12           May-13

Source: Morgan Stanley Research


We highlight 30-year tails as they offer the best carry and
roll, and the smallest risk to a broad decline in vol. The ratio
of 2y30y to 1y30y implied vol is the lowest across tails. As a
result, investors can purchase 1y1y30y FVA at cheap levels
to the spot 1y30y and earn a 51bp profit if the rates and
vol are unchanged. Because of the higher 2y/1y expiry
ratios on other tails, those FVA constructions would result in
negative carry and roll down.

Moreover, we believe that intermediate tails would suffer
significantly if rates fell and volatility declined, creating
additional risk for losses. While those tails would likely
outperform if vol moved higher, the additional risk – without a



                                                                                                                                                   34
                                                                       MORGAN STANLEY RESEARCH

                                                                       May 31, 2013
                                                                       US Interest Rate Strategist




US Agency Mortgage-Backed Securities
All Eyes on Payroll Report
Vipul Jain (212) 761-2647                                              the selling from REITs and servicers stopped. During this
                                                                       period, continued selling from overseas investors was another
Michael Ortiz (212) 761 4212
                                                                       headwind for the mortgage market.
Emily Zheng (212)-761-1346
                                                                       Exhibit 1
    It was a wild ride in the agency MBS market over the past 2       FNCL OAS Over the Past 1-Year (bps)
     weeks. We recommended turning neutral on the mortgage
     basis in mid-May, based on three main concerns –
                                                                         80
     directionality of the mortgage basis, servicing hedging, and
     REIT selling. All our concerns were validated over the past 2
                                                                         60
     weeks.

    Mortgages have cheapened and rates are at the wider end             40
     of the range. However, there are other considerations before
     deciding to increase allocation to the mortgage basis after         20
     the recent widening. The single biggest issue next week is
     the May Non Farm Payroll report. We expect the report                 0
     could lead to a binary outcome for the mortgage basis
     performance and expect heightened volatility.                      -20

    We believe that money managers are the marginal buyers of          -40
     agency MBS which by itself is unlikely to lower the volatility
     or rate directionality that we have seen for the MBS market.       -60
     Overall, the risk reward tradeoff is not very favorable to
                                                                         May 12             Aug 12            Nov 12    Feb 13   May 13
     owning mortgages despite more attractive valuations. The
                                                                                    3                   3.5             4         4.5
     carry is much lower and realized volatility is highly elevated.
     And there is very high event risk in the near term. We            Source: Morgan Stanley Research, The Yieldbook
     continue to recommend a neutral stance regarding the
     mortgage basis and across the stack.                              After the recent underperformance of the mortgage basis the
                                                                       question is whether it is time to increase allocation to agency
                                                                       MBS market. The argument in support of going long the
It was a wild ride in the agency MBS market over the past 2            mortgage basis is simple. Mortgages have cheapened close
weeks. We recommended turning neutral on the mortgage                  to pre-QE3 levels and the rates are at the high end of the 1-
basis in mid-May, based on three main concerns:                        year range. Odds are potentially higher that the rates rally
                                                                       back from here or they stabilize here and mortgage spreads
     -    We expected mortgage performance to be very rate
                                                                       tighten back in that scenario. However, in the current
          directional.
                                                                       environment, this range may not hold and there are other
     -    We expected servicer hedging flows to kick in once           considerations as well.
          rates crossed 2% in 10-year USTs.
                                                                       Our rates strategists believe the market is priced for tapering
     -    And we expected REITs to reduce their holdings
                                                                       to begin in September 2013. Their view is that December is a
          over time to reduce the spread duration of their
                                                                       more likely time for tapering to begin. While this might suggest
          portfolios.
                                                                       a bullish stance toward duration, they remain tactically neutral
                                                                       and wait for the market to price a June/July tapering before
Price action over the past 2-weeks validated all these
                                                                       getting long duration. Exhibit 2 shows the expected level of
concerns. The OAS for FN3s has widened by 7 bps over the
                                                                       rates based on different expectations regarding tapering. Any
past 2 weeks (Exhibit 1). The total mortgage
                                                                       changes in expectations in this regard are likely to have a
underperformance over the past 2 weeks understates intraday
                                                                       significant impact on 10-year yields.
volatility that we have seen during this period, as there were
swings of close to half a point in mortgage performance
relative to their rate hedges. Over the past 2 days, mortgages
have regained some lost ground as rates have stabilized and

                                                                                                                                        35
                                                                            MORGAN STANLEY RESEARCH

                                                                            May 31, 2013
                                                                            US Interest Rate Strategist




Exhibit 2
Expected 10-Year Treasury Range in Various Expectations for Tapering/QE End
                                        5-Year Yield         7-Year Yield        10-Year Yield            30-Year Yield            10-Year Treasury
                                          Change               Change               Change                   Change                  Yield Range
No Purchases Beyond Sep                    44bp                 46bp                 46bp                     47bp                    2.50-2.55%
No Purchases Beyond Dec                    19bp                 20bp                 21bp                     21bp                    2.20-2.25%
No Purchases Beyond Mar 14                  -6bp                 -6bp                 -6bp                     -6bp                   1.95-2.00%
Taper Begins in June*                      36bp                 37bp                 38bp                     39bp                    2.40-2.45%
Taper Begins in July*                      25bp                 26bp                 26bp                     27bp                    2.25-2.30%
Taper Begins in September*                 11bp                 12bp                 12bp                     12bp                    2.10-2.15%
Taper Begins in October*                    0bp                  0bp                  0bp                      0bp                    2.00-2.05%
Taper Begins in December*                  -15bp                -15bp                -16bp                    -16bp                   1.85-1.95%
MS Projected Schedule*                     -15bp                -15bp                -16bp                    -16bp                   1.85-1.95%
No Purchases Beyond Jun                    73bp                 74bp                 73bp                     72bp                    2.75-2.80%
* Assuming the taper schedule implied by the Fed's dealer survey.
Source: Morgan Stanley Research                                              Exhibit 3
                                                                             Mortgage REIT Index (MVMORT)
In terms of macro events, the Non Farm Payroll report for the
month of May that will be released next week is the single                    420
biggest near term risk event for the rates and the mortgage
markets as it will play a critical role in shaping views                      400
regarding tapering. The consensus estimate is for a 165k
increase in non-farm payrolls. A better than expected NFP                     380
report is likely to push rates higher. In that scenario, we
would expect mortgages to underperform, and we are likely                     360
to see a re-run of what we saw over the past 2 weeks, i.e.,
servicer and REIT selling and very poor liquidity. However, if                340
the NFP report comes in worse than expected, we could
easily envision mortgages tightening by 10bps. If NFP report                  320
comes out in line with expectations, rates are likely to remain
range-bound and mortgage performance to remain mixed. In                      300
other words, there is a significant event risk with odds of a
                                                                              280
binary outcome, and we do not have a strong conviction in
either direction.                                                               Oct 10        Apr 11       Oct 11         Apr 12    Oct 12   Apr 13


In addition to near term event risks, the sources of demand                  Source: Morgan Stanley Research, Bloomberg

for agency MBS are not clear except for the Fed. The index
that tracks mortgage REIT stock prices has declined by close                 Also, Japanese investors are maintaining a more defensive
to 7%. Some of the individual names in the index have                        posture because of the selloff in rates, in Japan and
declined by close to 20%. We think it is very unlikely that                  worldwide. Also, given the higher JGB rates, the urgency to
REITs would either raise more capital or increase leverage                   invest in other overseas market has declined. We expect this
ratios voluntarily in the current market environment.                        trend to continue and don’t expect Japanese investors to be
                                                                             a significant source of demand in the near term.

                                                                             At this point all eyes are on potential bank demand at the
                                                                             current rate levels. Bank demand has remained weak so far
                                                                             this year. A case can be made that at the current yield levels,
                                                                             banks should be better buyers of agency MBS. However,
                                                                             bank demand for agency MBS is highly dependent on rate
                                                                             outlook. They are unlikely to step in unless rates stabilize.
                                                                             Given the change in the treatment of gain and loss in the

                                                                                                                                                      36
                                                                          MORGAN STANLEY RESEARCH


                                                                          May 31, 2013
                                                                          US Interest Rate Strategist


OCI account for the purposes of regulatory capital, banks are              favorable to owning mortgages despite more attractive
likely to be even more sensitive to their rate outlook. This               valuations. The carry is much lower and realized volatility is
leaves us primarily with money managers as the marginal                    highly elevated. And there is very high event risk in the near
source of demand for agency MBS in the current                             term. We continue to recommend a neutral stance regarding
environment. Money managers may look to buy mortgages                      the mortgage basis and across the stack.
for the spread tightening potential, but the carry advantage of
mortgages has diminished significantly. After the recent                   Exhibit 5
backup in rates and curve steepening, the model durations                  MSR Duration Profile in 10y UST equivalents ($bn)
for FN 3 have extended. On top of that, mortgages are
trading much longer than the model hedge ratios, and                             0
rolldown and carry of the hedges have increased. As a                         -10
result, there is limited advantage to owning FN 3 relative to
                                                                              -20
10 year-USTs. In contrast, at the beginning of May, carry for
FN 3s was 2 ticks better relative to 10-year USTs (Exhibit 4).                -30
                                                                              -40
Exhibit 4
                                                                              -50
Hedge Adjusted Carry for Mortgages (Ticks)
                                                                              -60
                                         10-yr Carry +          Dur Adj
                    Mtg Price     Roll    Roll Down      HR      Carry        -70
            FNCL 3   100.90       8.88       10.50       0.79    0.55
                                                                              -80
 5/30/2013 FNCL 3.5  103.89       8.88       10.50       0.67    1.81
            FNCL 3   104.75       8.75       9.50        0.61    2.95         -90
 5/1/2013 FNCL 3.5   106.59       7.63       9.50        0.44    3.48
Source: Morgan Stanley Research                                             -100
                                                                                       -50     -25      0       25      50   75   100 125 150
We don’t expect money manager demand to be counter-
cyclical, and it is unlikely to lower the volatility in the agency         Source: Morgan Stanley Research, The Yieldbook
MBS market. In addition, the MSR universe is negatively
convex at current rate levels (Exhibit 5), and those flows will
continue to add rate directionality to the mortgage basis
performance. Overall, the risk reward tradeoff is not very




                                                                                                                                           37
                                                                                 MORGAN STANLEY RESEARCH

                                                                                 May 31, 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                  0.295            5.1           2y              0.458             7.2                         2y                 16.2            2.1
         3y                  0.486            7.3           3y              0.655            11.2                         3y                 16.9            3.9
         5y                  1.015           12.5           5y              1.200            14.4                         5y                 18.5            2.0
         7y                  1.496           10.9           7y              1.723            14.0                         7y                 22.7            3.1
        10y                  2.123            9.8          10y              2.288            13.0                        10y                 16.5            3.3
        30y                  3.286            7.6          30y              3.211             7.9                        30y                 -7.5            0.2
      2s/3s         (bp)      19.1            2.3        2s/3s      (bp)     19.8             4.1                      2s/3s                  0.7            1.8
      3s/5s                   52.9            5.1        3s/5s               54.5             3.2                      3s/5s                  1.6           -1.9
      5s/7s                   48.1           -1.6        5s/7s               52.3            -0.5                      5s/7s                  4.2            1.1
     7s/10s                   62.7           -1.1       7s/10s               56.5            -1.0                     7s/10s                 -6.2            0.1
    10s/30s                  116.3           -2.1      10s/30s               92.3            -5.1                    10s/30s                -24.0           -3.0
   2s/3s/5s                  -16.9           -1.4     2s/3s/5s              -17.3             0.4                   2s/3s/5s                 -0.4            1.9
  2s/5s/10s                  -19.4            5.0    2s/5s/10s              -17.3             4.4                  2s/5s/10s                  2.1           -0.7
  5s/7s/10s                    -7.3          -0.2    5s/7s/10s                -2.1            0.2                  5s/7s/10s                  5.2            0.5
 5s/10s/30s                    -2.7          -0.3   5s/10s/30s                 8.3            1.9                 5s/10s/30s                 11.0            2.1

                  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                   6                9                GN/FN 3.5                1-15+         -0-13+
   2y FNMA                   -20.3           -5.1    FNMA 4.0                   7                3                GN/FN 4.0                0-190         -0-22+
  2y FHLMC                    -3.0           -3.0    FNMA 4.5                  11                0                GN/FN 4.5               -0-01+         -0-11+
   3y FNMA                     9.5            0.7    FNMA 5.0                  45               -5                GN/FN 5.0               -0-00+         -0-03+
  3y FHLMC                     3.0           -2.0
                                                      Mortgage Performance vs. Swaps                                            Gold/Fannie Swaps
    3y FHLB                  -12.3           -4.1
   5y FNMA                    15.0           -2.0      Coupon                Price         1w Perf                     Swap       Spread (32nds)         1w Chg
  5y FHLMC                     9.5           -1.8    FNMA 3.5           103-28+            -0-27+                 FG/FN 3.5               -0-082         -0-01+
    5y FHLB                    0.0           -1.3    FNMA 4.0            105-21            -0-13+                 FG/FN 4.0               -0-07+          0-000
  7y FHLMC                    22.5            1.8    FNMA 4.5           106-31+            -0-05+                 FG/FN 4.5               -0-260         -0-00+
 10y FHLMC                     0.0            1.4    FNMA 5.0           107-29+            -0-02+                 FG/FN 5.0               -1-000          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                  0.58          11.49     3m x 2y                 35.5           11.6                     TII4/15             -0.99%           13.6
     1y x 2y                  0.82          15.18     3m x 5y                 73.8           17.3                     TII4/18             -0.86%           20.6
     2y x 2y                  1.38          20.06    3m x 10y                 86.4           11.7                     TII1/23             -0.08%           20.0
     2y x 5y                  2.26          16.99     6m x 2y                 39.9           13.1                     TII2/43              0.96%           13.2
     3y x 2y                  2.04          19.65     6m x 5y                 75.4           14.1
                                                                                                                       US TIPS - Breakeven Inflation
     3y x 5y                  2.77          15.83    6m x 10y                 85.8            9.2
    3y x 10y                  3.37          12.36     1y x 10y                89.2            8.5                    Maturity            BEI (bp)    1w Chg (bp)
     4y x 5y                  3.19          13.98      2y x 5y                91.5            9.7                     TII4/15             127.09            -9.8
     5y x 5y                  3.53          12.35     3y x 10y                94.0            4.9                     TII4/18             182.94           -10.5
    5y x 10y                  3.83           9.66      5y x 5y                97.8            3.3                     TII1/23             202.07           -10.1
   10y x 10y                  4.12           5.33     5y x 10y                93.3            2.4                     TII2/43             231.62            -3.9
   10y x 20y                  4.00           4.47    10y x 10y                84.5            0.1

             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                   0.095           -1.5       Target              0.125                                    MS FCI                -0.60          -0.03
  GCF Jul13                  0.105           -0.5    4/30/2014               0.16             2.0                   S&P 500             1,654.41          -0.94
 GCF Aug13                   0.115            0.0    6/18/2014               0.17             3.0              DJ Industrials          15,324.53          17.36
 GCF Sep13                   0.125            1.0    7/30/2014               0.19             3.5                  USD/JPY               100.720         -2.430
 GCF Oct13                   0.135            0.5    9/17/2014               0.21             4.8                 USD/EUR                  1.305          0.019
 GCF Nov13                   0.140            1.0   10/29/2014               0.23             5.5                  10y Bund               1.51%            8.67
                                                    12/17/2014               0.26             6.8                   10y JGB               0.89%            0.49
                Eurodollar Futures
                                                     1/28/2015               0.28             7.5                    10y Gilt             1.95%            6.47
        Pack               Rate (%)   1w Chg (bp)    3/18/2015               0.33             8.0                       Gold             1412.60          48.10
     Whites                   0.34            2.6    4/29/2015               0.36             8.5                   Gasoline              281.25          -0.69
      Reds                    0.59           10.9    6/17/2015               0.41             9.5              3m Libor -OIS               16.77           0.69
     Greens                   1.07           17.7     8/5/2015               0.46            10.1                CDX NA IG                 76.34           4.74
      Blues                   1.78           19.9    9/23/2015               0.52            10.5                        VIX               14.53             0.7

Source: Morgan Stanley Research
All levels as of close: 30-May-13




                                                                                                                                                                   38
                                                                                                                           MORGAN STANLEY RESEARCH


                                                                                                                           May 31, 2013
                                                                                                                           US Interest Rate Strategist



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


Treasuries


Long 5s/10s/30s 60:62 Fly                 We look for duration neutral RD&C trades with a protection against tail risks     1/10/2013     -        -98.10    -107.40    -110.00    -80.00    bp running    11.00



                                          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     -43.60    -40.00     -58.00    bp running    2.60
                                          increased Fed purchases being priced in.




TIPS

                                          We like positioning for a continued reallocation out of the product by end-
5s/30s Breakeven Steepener                users via short breakeven trades. The level of breakevens is directional          5/31/2013     -         43.00     43.00      60.00      35.00    bp running    0.00
                                          with the curve shape.


                                          We like positioning for a continued reallocation out of the product by end-
Short 10-year BEI                                                                                                           5/31/2013     -        220.00    220.00     205.00     225.00    bp running    0.00
                                          users via short breakeven trades.




Swaptions


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      0.50       10.00      -5.00    bp running    0.50
OTM on 1s and 23 bp OTM 2s


Buy 100mm 1y10y ATMF, sell 100mm This trade earns high levels of RDC, and only loses if 10y20y rates fall past                                                                                 bp of
                                                                                                                            4/4/2013      -         0.00      22.00      75.00     -25.00                  22.00
1y30y 39bp OTM receivers         historic lows.                                                                                                                                               notional


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     10.60      60.00      15.00                 -18.40
                                                                                                                                                                                              notional
pay 29bp

Long 10y tails on the 1y 5s/10s/30s
                                          This trade is a cheap hedge on lower rates, as the 10y leg is well correlated
receiver fly, with 10y tail struck 6 bp                                                                                     5/16/2013     -         0.00      1.10       15.00     -15.00    bp running    1.10
                                          to it.
OTM for zero cost

Pay 6.25bp upfront, buy ATMF and
                                      3m3y rates offer the best vol-adjusted RDC on the surface, and the payout
15bp low 3m3y rcvr, sell 2x 7.5bp low                                                                                       5/16/2013     -         2.10      1.30       5.00       0.00     bp running    -0.80
                                      range is attractive to history
rcvr


                                                                                                                                                                                               bp of
Pay 1250bp, buy 1y1y30y FVA               Good way to go long vol with limited downside, positive carry                     5/30/2013     -        1250.00   1250.00    1400.00    1200.00                 0.00
                                                                                                                                                                                              notional




Swaps

                                          During the recent selloff, this PCA fly has reached an extreme level. The
PCA EDN3/EDZ3/EDM4 Fly
                                          trade is uncorrelated with rates and has remained in a limited range over         5/29/2013     -        -10.00     -10.00    -11.60      -9.00    bp running    0.00
(1.12:0.31)                               the last few months. Therefore, we recommend fading the extremity

                                          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     31.10      31.00      25.00    bp running    2.60
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 trade    4/11/2013     -         17.60     10.20      15.00      19.00    bp running    -6.90
                                          is likely to profit.


                                          This trade has a high level of RDC. Our analysis shows that it is relatively
Recv 203mm 5s, pay 107mm 10s,                                                                                                                                                                  bp of
                                          hedged for small moves in rate, but is inherently short convexity. However,       5/9/2013      -         22.00     37.10      35.00     -15.00                  71.50
recv 60mm 5y5y                                                                                                                                                                                notional
                                          we can short vol at an attractive level via this trade.


                                          Over the past few weeks, as we have seen a significant cheapening of the
Long ED12 on ED4/ED12/ED20 Fly            belly during the recent selloff, attractive rolldown opportunities have           5/16/2013     -        -34.80     -24.50    -40.00     -30.00    bp running   -10.30
                                          presented themselves in Eurodollar flies.




                                                                                                                                                                                                               39
                                                                                                     MORGAN STANLEY RESEARCH


                                                                                                     May 31, 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    -12.50     -10.00    -17.00   ticks    2.50
                            demand to pick up at these levels.



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 31, 2013) for a 1-year history of our trades.




                                                                                                                                                                                  40
                                                                        MORGAN STANLEY RESEARCH

                                                                        May 31, 2013
                                                                        US Interest Rate Strategist




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


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


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


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


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

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




                                                                                                                              41
                                                                                MORGAN STANLEY RESEARCH

                                                                                May 31, 2013
                                                                                US Interest Rate Strategist




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                         Coverage Universe    Investment Banking Clients (IBC)
                                        % of                   % of % of Rating
Stock Rating Category       Count       Total     Count Total IBC Category
Overweight/Buy               1034        36%         399        39%         39%
Equal-weight/Hold            1250        44%         479        47%         38%
Not-Rated/Hold                105         4%          27         3%         26%
Underweight/Sell              473        17%         123        12%         26%
Total                       2,862                   1028
Data include common stock and ADRs currently assigned ratings. An investor's decision to buy or sell a stock should depend on individual
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Analyst Stock Ratings

                                                                                                                                                    42
                                                                                            MORGAN STANLEY RESEARCH

                                                                                            May 31, 2013
                                                                                            US Interest Rate Strategist




Overweight (O). The stock's total return is expected to exceed the average total return of the analyst's industry (or industry team's) coverage
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                                                                                                                                                                          43
                                                                                          MORGAN STANLEY RESEARCH

                                                                                          May 31, 2013
                                                                                          US Interest Rate Strategist




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5-31-13 po/jf/sm




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                                                         MORGAN STANLEY RESEARCH




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Description: We believe the market is priced for tapering to begin in September 2013. Our view is that December is a more likely time for tapering to begin. While this might suggest a bullish stance toward duration, we remain tactically neutral. We also turn neutral on the yield curve and stop-out of our 7s/30s and 10s/30s curve steepeners. If the market prices a June/July tapering, we will consider moving overweight duration and reentering our curve steepeners.