Two Treasury Forecasts: a Grand Canyon-Size Gap

Goldman and Morgan at Odds as Yield Forecasts Paint Picture of Uncertainty .ArticleComments (4)more in Economy ».EmailPrintSave This ↓ More.
Investors befuddled by dramatic moves in the 10-year Treasury yield won't get much help from the sages of Wall Street.

Some of the smartest prognosticators are sharply divided on the direction of Treasurys, a split echoed by the gyrations of the yield itself. This week, the yield swung from just above 4% on Monday to as low as 3.84% on Thursday and back to as high as 3.93% on Friday as investors were alternately fearful and sanguine about the market's willingness to digest the U.S. government's record supply of new debt.

Meanwhile, the two best economic forecasting teams of the past two years couldn't disagree more about where Treasurys will go next. Morgan Stanley believes the 10-year yield will rise to 5.5% this year, the highest estimate among top Treasury dealers. Goldman Sachs Group Inc. says yields are headed back down to 3.25%.



The 2.25 percentage-point gap between those forecasts represents a gulf when it comes to corporate, consumer and government borrowing costs. Where Treasurys wind up could hold the key to the pace of the economic recovery—and the direction of the stock market—given that a strong economy might be able to withstand a spike in rates but a shaky economy might not.

Goldman's forecast, for example, would put mortgage rates, which theoretically move in step with 10-year Treasury yields, at about 5%, their generational low. Morgan Stanley's forecast would put them somewhere north of 7%, the highest in a decade.

Since 2003, Treasury yield forecasts by economists have differed more only in late 2008 and early 2009, when the credit crisis was raging and the economy was an even bigger question mark, according to tallies by The Wall Street Journal surveys of economists.


And seldom have the best forecasters been so far apart. Morgan Stanley's economic and rate forecasts were No. 1 in 2009, while Goldman led the pack in 2008. The second-ranked forecasters in 2008 and 2009 don't agree, either. Kurt Karl of Swiss Re, last year's No. 2, sees the 10-year yield ending 2010 at 3.8%. And 2008's No. 2, Ram Bhagavatula, of Combinatorics Capital, thinks the yield will rise to 5%.

At Morgan Stanley, head of interest-rate strategy Jim Caron reasons that the market can't withstand an estimated $2.4 trillion of debt the U.S. government is expected to sell this year without yields rising. Because yields move inversely to price, they go up as prices decline.



"We've never seen this much Treasury supply in the history of the bond market," Mr. Caron said in a phone call this past week. Morgan Stanley's strategists and economists, including Richard Berner and David Greenlaw, also take into account a view that the economy, private credit demand and inflation expectations will rebound more quickly than many analysts expect.



In some respects, Morgan Stanley's view looks extreme: 5.5% would be the highest yield since May 2001. That was two recessions, two stock-market bottoms and one real-estate bubble and bust ago. In comparison, the broad consensus is that the 10-year yield will rise to just 4.24% by year's end, according to the latest Wall Street Journal survey of economists.

"I never really thought about [our forecast] as being the outlier," Mr. Caron said. "In our view, the consensus is wrong."

At the other extreme, Goldman's view is that record government borrowing is merely replacing missing private credit demand, which will return slowly. Even without a double-dip recession, unemployment and other measures of economic "slack" will stay high, snuffing inflation, which is typically a key driver of interest rates, Goldman predicts.

"Ultimately, we don't find supply to be of such great predictive power regarding what happens to interest rates," said Goldman Sachs economist Jan Hatzius.



The divergence of views between Morgan Stanley and Goldman is reflected in debates taking place around the world, including the boardroom of the Federal Reserve. Economic iconoclasts Jim Grant and David Rosenberg recently debated the subject in a video enjoying heavy Internet rotation this week.



"You'll find more bargains in your hotel mini-bar than you will in the Treasury yield curve," said Mr. Grant, editor of Grant's Interest Rate Observer.



"You don't go through bear markets in Treasurys unless the Fed is tightening monetary policy, which I frankly believe is years down the road," countered Mr. Rosenberg, chief economist at Gluskin Sheff in Toronto.



After this past week's rebound, including an auction Wednesday that brought the highest demand for 10-year Treasurys since 1994, the momentum is on the side of the Treasury bulls, if only for now.



And Treasury yields are still lower than before the recession began in 2007, despite record government borrowing and budget deficits.

This isn't unprecedented. David Ader, head government-bond strategist at CRT Capital, recently noted that government borrowing costs have fallen in Canada, Japan and the U.K. even as those countries racked up hefty budget deficits.



Even if supply alone is enough to drive rates dramatically higher and the economy isn't strong enough to handle it, then the recovery could be at risk, at least in housing. That could hurt the economy or lead the Fed to ramp up its Treasury purchases, either of which would drive yields lower.



But the case by Treasury bears for higher rates depends partly on an expectation that the economy can handle it. Though the 1.65 percentage-point jump in yields Morgan Stanley expects this year would be unusually large, it isn't unprecedented. In fact, Treasury yields surged 1.6 percentage points last year, and the economy managed to recover anyway.



Write to Mark Gongloff at mark.gongloff@wsj.com