If you're long the 10-year, you're betting on everything in the world going perfectly -- no serious inflation, no macro debt risk -- according to latest from Morgan Stanley:

Fed Chairman Bernanke’s speech on Monday could not have

been better tailored to keep bond markets happy. The

commitment to keep policy rates “exceptionally low” for an

“extended period” and the benign outlook for inflation were

both very well received by bond markets, as well as other

risky assets. Obligingly, the Survey of Professional

Forecasters (SPF) showed a drop in both the 1-year ahead

and the 10-year ahead CPI inflation expectations in its 4Q

release. Our proprietary model, MS FAYRE, shows a current

fair value of 3.3% for the US 10-year Treasury yield (see

Exhibit 1) – bang in line with actual yields. Bond markets

seem to be priced for perfection, anticipating that the ‘sweet

spot’ created by exceptionally low policy rates and benign

inflation will remain in place for a long time.

Even if you believe that inflation will play fair, investors seem

to be receiving no compensation at all for the macroeconomic

risks that have surely made an indelible impression over the

last two years, or for the fiscal risks that abound. Finally, such

sanguine expectations in US bond markets put downward

pressure on bond yields elsewhere in the world, making it

difficult for central banks that wish to tighten policy ahead of

the major central banks to gain significant traction through

higher bond yields.

Priced for perfection… MS FAYRE generates its fair value

estimate using the real fed funds rate, 1-year ahead CPI

inflation expectations from the SPF conducted by the

Philadelphia Fed and the 5-year rolling standard deviation of

inflation as a proxy for inflation volatility (for more details on

the MS FAYRE model, see Fairy Tales of the US Bond

Market, July 26, 2006). With the fed funds rate at 12.5bp, core

PCE inflation tracking at 1.3% and the 4Q09 number for

1-year ahead CPI inflation expectations from the SPF coming

in at 1.6%, MS FAYRE produces a fair value of 3.3% for

10-year bond yields, which is exactly where the 10-year yield

is now (interested readers should contact us for a user-

friendly spreadsheet for simulating the FAYRE model).

Forward-looking bond markets thus seem to be pricing in

altogether too rosy a scenario for the foreseeable future.

…for now: With actual bond yields bang in line with our

fundamental fair value estimate, investors seem to be

receiving no compensation for macroeconomic or fiscal risks.

Risk premiums declined precipitously before the Great

Recession and should return to a reasonable level,

particularly in light of the macroeconomic risks that have

made themselves felt over the last couple of years. Further,

with the bulk of the approved fiscal package in the US yet to

be spent, the successful handling and eventual retirement of

debt seems very far away with plenty of risks along the way.

Bond markets have clearly not turned their attention to these

issues yet, but it is unlikely that they will ignore them forever.



