摩根士丹利：全球宏观策略-失去信心？

August 13, 2021 11:12 PM GMT Global Macro Strategist | Global Losing Confidence? We are not losing confidence in our view that US Treasury yields and the US dollar are headed higher. Labor market strength and a powerful wealth effect should prevent the same loss of confidence in other household measures that was seen in the University of Michigan survey. Fed taper on tap. Interest Rate Strategy We maintain outright short 10y USTs and EDZ2Z4 steepeners. We maintain long 10y DBR vs. short 10y UST and long 10y Italy vs. short 10y Spain. We maintain long 10y JGB ASW vs. 3m DTIBOR, long 20y JGBASW vs. 3m DTIBOR/TONA OIS, and pay 2y1y TONA OIS. We keep receiving the November RBNZ and maintain 5s30s Australia steepeners. We introduce a suite of P1KE and P0KE tickers for G10 countries. Currency & Foreign Exchange We stay bullish the USD versus EUR, JPY and CHF via options. Fed tapering is likely to bolster the USD even if it's delayed. We add short CHF/NOK, which should benefit from a steeper US 2s10s curve and a hawkish Norges Bank. We expect an RBNZ "dovish liftoff" and stay long AUD/NZD. We discuss how pension funds' rebalancing flow weigh on CCY/JPY price action and recommend long CAD/JPY positions. Inflation-Linked Bonds We maintain 10y beta-weighted breakeven tighteners (DV01 0.7:1). Looking at July CPI through trimmed means – we think July CPI was strong under the hood, with the V-shaped recovery in shelter intact. We consider the rebasing of Japan's CPI (from 2015 to 2020) along with potential ramifications for JGB linkers. We are sticking with a target level of 30bp for the newest JGBi breakeven. Short-Duration Strategy We demonstrate why reserves have not increased meaningfully in months. RRP usage can be explained not only by MMF AUM growth, but also by Tbill paydowns. In a delayed debt ceiling, repo could experience modest noise. Unsecured funding could widen due to risk-off sentiment. Interest Rate Derivatives We discuss callable issuance, which has been slow this summer despite some significant deals hitting the market this week. We think that $15-17bn of bonds currently in the market will be refinanced next year. We suggest entering 10s30s spread curve flatteners in line with our fair value models. Please click here if you would like to receive the daily Global Macro Commentary. MORGAN STANLEY & CO. LLC Matthew Hornbach STRATEGIST Matthew.Hornbach@morganstanley.com Guneet Dhingra, CFA STRATEGIST Guneet.Dhingra@morganstanley.com David S. Adams, CFA STRATEGIST David.S.Adams@morganstanley.com Andrew M Watrous STRATEGIST Andrew.Watrous@morganstanley.com Kelcie Gerson STRATEGIST Kelcie.Gerson@morganstanley.com David Harris STRATEGIST David.G.Harris@morganstanley.com +1 212 761-1837 +1 212 761-1445 +1 212 761-1481 +1 212 761-5287 +1 212 761-3983 +1 212 761-0087 MORGAN STANLEY & CO. INTERNATIONAL PLC+ James K Lord STRATEGIST James.Lord@morganstanley.com +44 20 7677-3254 Sheena Shah STRATEGIST Sheena.Shah@morganstanley.com +44 20 7677-6457 Gek Teng Khoo STRATEGIST Gek.Teng.Khoo@morganstanley.com +44 20 7425-3842 John Kalamaras STRATEGIST John.Kalamaras@morganstanley.com +44 20 7677-2969 Alina Zaytseva STRATEGIST Alina.Zaytseva@morganstanley.com +44 20 7677-1120 MORGAN STANLEY MUFG SECURITIES CO., LTD.+ Koichi Sugisaki STRATEGIST Koichi.Sugisaki@morganstanleymufg.com +81 3 6836-8428 Shoki Omori STRATEGIST Shoki.Omori@morganstanleymufg.com +81 3 6836-5466 Due to the nature of the fixed income market, the issuers or bonds of the issuers recommended or discussed in this report may not be continuously followed. Accordingly, investors must regard this report as providing stand-alone analysis and should not expect continuing analysis or additional reports relating to such issuers or bonds of the issuers. Morgan Stanley does and seeks to do business with companies covered in Morgan Stanley Research. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of Morgan Stanley Research. Investors should consider Morgan Stanley Research as only a single factor in making their investment decision. For analyst certification and other important disclosures, refer to the Disclosure Section, located at the end of this report. += Analysts employed by non-U.S. affiliates are not registered with FINRA, may not be associated persons of the member and may not be subject to FINRA restrictions on communications with a subject company, public appearances and trading securities held by a research analyst account.​ 1 Global Macro Strategy MORGAN STANLEY & CO. LLC Matthew Hornbach Matthew.Hornbach@morganstanley.com David Adams, CFA David.S.Adams@morganstanley.com Andrew Watrous Andrew.Watrous@morganstanley.com +1 212 761-1837 +1 212 761-1481 +1 212 761-1837 Are We Losing Confidence? No, we are not losing confidence in our view that US Treasury yields and the US dollar are headed higher. In the US, markets understandably reacted strongly to the University of Michigan consumer sentiment preliminary report for August. It was a summer Friday, and the idea that sentiment is worse today than at the height of the pandemic is a riddle, wrapped in a mystery, inside an enigma. The 70.2 preliminary reading was the lowest since December 2011, when the unemployment rate was near 8.5% – over 3pp higher than today. The S&P 500 Index ended 2011 flat, but was down just over 5% heading into December. In stark contrast, the S&P 500 Index is up almost 19% in 2021. Not all surveys of consumer confidence flash warning just yet. The Conference Board consumer confidence survey results for July printed at pre-pandemic levels – opening a large divergence from the Michigan survey (see Exhibit 1 and Exhibit 2). Naturally, it could fall in August as well, but we suspect it will remain disconnected. The Conference Board survey is more geared toward the labor market, while the Michigan survey is geared toward personal finances and business conditions. Exhibit 1: U of Mich consumer sentiment and Conf Board consumer confidence Index Index 160 120 140 Jul 110 120 100 100 90 80 80 60 40 70 Aug 20 60 0 Aug-81 50 Aug-91 Aug-01 Aug-11 Aug-21 Conference Board consumer confidence U of Mich consumer sentiment (rhs) Source: Morgan Stanley Research, U of Michigan, Conference Board Exhibit 2: U of Mich consumer sentiment vs. Conf Board consumer confidence Conference Board consumer confidence 160 y = 1.90x - 71.73 R² = 0.78 140 Jul 120 100 80 60 40 20 0 50 August U of Mich at 70 60 70 80 90 100 110 120 U of Michigan consumer sentiment Source: Morgan Stanley Research, U of Michigan, Conference Board Note: Regression uses monthly data back to August 1981 2 What drove the consumer sentiment to such depths in August? First, it's worth mentioning that only 439 households took the survey. That's right: responses from 439 households allowed for 10y Treasury yields to decline 5bp into the Friday close. Nevertheless, all 5 components of the index fell, as households are struggling with the idea that the pandemic isn't over and prices may keep rising, eroding real incomes (see Exhibit 3). Still, one component that drove the sentiment index lower stood out. Expectations for business conditions over the next year returned to levels that existed about a year ago (see Exhibit 4). At the same time, assessments of business conditions today compared to a year ago remain buoyant. Typically, expectations for the next year move closely in line with how things have gone over the past year. Not so in August, apparently. We think investors should approach this data with skepticism, especially given the rapidly improving labor market – not captured in the University of Michigan survey. Exhibit 3: Expected household income in 1 year and expected real income in 1-2 years Index Index 160 100 155 95 150 145 90 140 85 135 80 130 125 75 120 70 Aug-16 Aug-17 Aug-18 Aug-19 Aug-20 Aug-21 Expected income in 1 year Expected real income in 1-2 years (rhs) Source: Morgan Stanley Research, University of Michigan Exhibit 4: Business conditions expected in 1 year and current business conditions compared to 1 year Index 160 140 120 100 106 80 72 60 40 20 0 Aug-16 Aug-17 Aug-18 Aug-19 Aug-20 Aug-21 Business conditions expected in 1 year Business conditions compared to 1 year ago Source: Morgan Stanley Research, University of Michigan At the same time, we wouldn't be surprised if the Conference Board measure declined for August as well. Recent readings of consumer confidence have been higher than our two-factor model would have suggested. The U-3 unemployment rate and the 3-year % change in the S&P 500 Index have explained 72% of consumer confidence since 1996. The unemployment rate on its own has explained 60%. Our two-factor model projects a 109 reading for Conference Board consumer confidence in August, down 20 points from the July reading (see Exhibit 5). However, the index has run between 15 and 24 points above our model projection since March. And our projection has risen steadily alongside the decline in unemployment and rise in equity prices (see Exhibit 6). Given the historical relationship between consumer confidence, the labor market, and wealth (equities); the outlook for the labor market; and the abundance of liquidity keeping financial conditions easy – supporting the wealth effect, we think investors should fade the fall in the University of Michigan gauge and remain underweight US Treasury duration and long the US dollar. 3 Exhibit 5: Conference Board consumer confidence vs. twofactor model projection Index 150 130 129 110 109 90 70 50 30 10 -10 -30 Jul-96 Jul-01 Jul-06 Jul-11 Jul-16 Jul-21 Conference Board consumer confidence 2-Factor Model Source: Morgan Stanley Research, BLS, Conference Board, Bloomberg Exhibit 6: US unemployment rate and 3-year % change in S&P 500 Index % 140 120 100 80 60 40 20 0 -20 -40 -60 Jul-96 Jul-01 Jul-06 S&P 500 3-year % change % 16 14 12 10 8 6 4 2 Jul-11 Jul-16 Jul-21 U-3 unemployment rate (rhs) Source: Morgan Stanley Research, BLS, Bloomberg Off-speed Pitches Can Strike Out Batters Too In the sport of baseball, pitchers can dominate a game. This is especially true when they use substances or other methods that change the flight dynamics of the ball. Pitchers have smeared, sliced and scuffed baseballs over the long history of the game. But this "advantage" alone doesn't explain pitching dominance. More well-rested arms throughout the game has helped as well. In the MLB, just over 4 pitchers threw during each game, on average, in the decade ending 2019. This compares to just over 1.5 pitchers at each game, on average, in the decade ending 1919 (see Exhibit 7). Despite these advantages, the number of Major League Baseball (MLB) no-hitters (including combined no-hitters) hasn't increased notably over the past century (see Exhibit 8). A team throws a no-hitter when the opposing team doesn't reach base from a hit over at least 9 innings of play. Exhibit 7: Average number of MLB pitchers used per game each decade back to 1900 # of pitchers used per game 4.5 4.0 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0 '10 '20 '30 '40 '50 '60 '70 '80 '90 '00 '10 Decade beginning in this year # of pitchers/game Source: Morgan Stanley Research, Baseball-reference.com, Wikipedia Exhibit 8: Number of MLB no-hitters per decade as % of games played back to 1900 % 0.25 0.20 0.15 0.10 0.05 0.00 '10 '20 '30 '40 '50 '60 '70 '80 '90 '00 '10 Decade beginning in this year # of no hitters as % of games played Source: Morgan Stanley Research, Baseball-reference.com, Wikipedia 4 Like success in many sports, success in pitching is often more mental than physical, and control often dominates speed. Some batters are better at hitting fastballs, some better at hitting slower pitches. Some batters are better at hitting inside pitches, some better at low pitches. In recent years, MLB catchers wear wristbands with information on batters gleaned from statistics. This allows them to tell pitchers the best pitches to throw for a given batter. And with this knowledge, pitchers with a wider range of pitches and/or more control can dominate. Some of the best pitchers don't throw with the most speed. How does this apply to macro markets today? Central banks don't have to throw liquidity at markets quickly (fastballs) in order for the liquidity they do provide to have an impact (a strike-out). Too much has been made of the Y/Y rate of change decline in global liquidity, money supply, GDP growth, etc. (see Exhibit 9, and All About the Money Supply). As long as central banks provide enough liquidity via QE, the wheels of transactional finance will remain lubricated. In Do Deficits Destroy Liquidity?, we discussed the topic in depth. When it comes to liquidity, our focus has been on both "narrow" and "broad" measures, as defined by Goodfriend (2000). And we expect both types of liquidity to keep expanding through the end of 2021 and into 2022. Central bank purchases of private sector assets (government bonds, corporate bonds, agency MBS) feature heavily in both types of liquidity injection. Exhibit 10 shows that central banks in the G10 will provide 23% less monthly liquidity in August than earlier this year. And yet, the monthly liquidity injection still amounts to 0.58% of annual nominal GDP. Exhibit 9: Global central bank liquidity proxy Y/Y % 40 35 30 25 20 15 13 10 5 0 -5 Jul-07 Jul-09 Jul-11 Jul-13 Jul-15 Jul-17 Jul-19 Jul-21 Global Liquidity Y/Y Source: Morgan Stanley Research, Bloomberg * Note: Includes Fed, ECB, BoJ balance sheets and international reserve assets ex-gold Exhibit 10: Total G10 central bank monthly QE, all assets, as % of annual nominal GDP*: 2021 maximum vs. August 2021 US$ billions 400 350 337.7 300 250 -23% 261.6 200 0.74% of 2020 150 annual GDP 100 0.58% of 2020 annual GDP 50 0 Max 2021 Pace Aug 2021 Pace USD (bn) Source: Morgan Stanley Research, National Central Banks, World Bank * Note: End of 2020 annual nominal GDP 5 This August, the G10 central banks will remove US$262 billion of securities ($199 billion of which will be government bonds) from private markets. While this is down from the US$338bn of securities the G10 central banks removed every month at the peak this year, it remains a considerable sum on a variety of metrics (see Exhibit 11 and Exhibit 12). Relative to nominal GDP, the RBA and RBNZ have reduced liquidity provision the most1. Exhibit 11: G10 central bank monthly QE, all assets: 2021 maximum vs. August 2021, in USD US$ billions 140 128 120120 120 100 94 80 60 40 30 19 21 20 20 13 6 7 53 10 20 0 Fed BoC ECB BoJ BoE Riks RBA RBNZ Maximum 2021 Pace August 2021 Pace Source: Morgan Stanley Research, National Central Banks Exhibit 12: G10 central bank monthly QE, all assets, as % of annual nominal GDP*: 2021 maximum vs. August 2021 % of annual GDP 1.6 1.5 1.4 1.2 1.0 1.0 0.8 0.8 0.7 0.6 0.60.6 0.4 0.4 0.4 1.1 1.0 0.8 0.6 0.8 0.8 0.2 0.1 0.0 0.0 Fed BoC ECB BoJ BoE Riks RBA RBNZ Maximum 2021 Pace August 2021 Pace Source: Morgan Stanley Research, National Central Banks, World Bank * Note: End of 2020 annual nominal GDP Exhibit 13 compares changes in liquidity provision across central banks on the basis of central bank balance sheet size. Exhibit 14 compares changes in liquidity provision via government bonds only on the basis of government bonds outstanding. For the Fed and ECB – the central banks providing the most liquidity every month on a nominal basis – the reduction in liquidity provision is very modest, indeed. Exhibit 13: G10 central bank monthly QE, all assets, as % of central bank balance sheet size*: 2021 maximum vs. August 2021 % of central bank balance sheet 8 7 6.8 6 5 4 3.6 2.9 3.0 3 2 1.6 1.5 1.6 1.5 2.0 2.1 1.0 1 0.3 0.1 0 3.1 2.4 0.0 Fed BoC ECB BoJ BoE Riks RBA RBNZ Maximum 2021 Pace August 2021 Pace Source: Morgan Stanley Research, National Central Banks * Note: balance sheet size at end-Q1 2021 used for maximum 2021 pace; the most recent size used for August 2021 pace Exhibit 14: G10 central bank monthly QE, gov't bonds, as % of gov't bonds outstanding: 2021 maximum vs. August 2021 % of Gov't Bonds Outstanding 3.5 3.0 2.9 2.5 2.2 2.0 1.7 1.5 1.4 1.4 1.2 1.0 0.9 0.9 1.0 0.7 0.50.5 0.5 0.2 0.4 0.2 0.0 0.0 Fed BoC ECB BoJ BoE Riks RBA RBNZ Maximum 2021 Pace August 2021 Pace Source: Morgan Stanley Research, National Central Banks, National Treasuries 6 And modest reductions in liquidity provision should have only modest effects on markets. It's little surprise that high-quality equity indexes have continued to rise, but at less rapid paces. For example, the S&P 500 index rose at a pace of over 100% per annum from March through September 2020 – when central bank liquidity provision was the greatest. As the Fed slowed the pace of QE in 2020, S&P 500 gains slowed as well. Between September 2020 and March 2021, the S&P 500 rose at an annualized pace of 50%. And from March 2021 through August month-to-date – as global central bank liquidity provision slowed modestly – the S&P 500 rose 35% annualized. Of course, the pace of QE could change more meaningfully in 2022, as we discuss in Trading the Taper. Changes to investor expectations about tapering – especially if radical – could have negative consequences for risky and risk-less asset classes alike. In the meantime, however, the slower, but steady drumbeat of central bank liquidity provision will continue. And while central banks aren't throwing "the heater" any longer, they still have a nasty change-up that can strike batters out (keep asset prices elevated) just as easily.2 Fed Tapering Supports the USD Market focus on Fed tapering is rising as we approach next week's FOMC minutes, which should give us quite a bit of color on the conditions under which the Committee might accelerate their tapering plans. This week we've examined how we think the USD might react under different tapering scenarios. For more detail, see USD | Trading Fed tapering Our economists have laid out four plausible scenarios to think about. One is their base case, which envisions a 12-month taper beginning in December 2021. There's also a similar "faster MBS" taper scenario, where the economic fundamentals are the same as the base case, but the FOMC speeds up the MBS element. There's also earlier-andfaster-taper and later-taper scenarios. We think tapering of just about any plausible shade is USD positive – the question is how much does it rise?: Morgan Stanley base case: USD stronger versus low-yielders, DXY gains 50bp/mo (Regime 2/3) as real yields rise but breakevens are little changed, so we straddle Regimes 2 and 3. USD gains are most concentrated versus low-yielding funders while risk currency performance is likely muted. Faster MBS taper: USD stronger versus low-yielders, DXY gains 50bp/mo (Regime 2/3) as FX responds in a similar manner to our base case economic scenario based on how real yields and breakevens respond. Earlier/faster taper: USD broadly stronger, DXY gains 150bp/mo (Regime 3) as real yields rise meaningfully and breakevens tighten as markets price in an earlier-thanexpected rate hike. 7 Later taper: USD gains except versus safe havens, DXY gains 20bp/mo (Regime 4) as real yields fall and breakevens tighten as a state of the world with a delayed tapering is also one where risk likely softens and safe havens gain. We see modest DXY gains in our base case and faster MBS tapering scenarios – an annualized pace of 6% per year. In both these cases, real yields rise but breakevens, which have already fully priced in the Fed's 2% average PCE goal, are likely little changed and stay rangebound. This scenario leaves most USD crosses little changed on net, with USD strength when breaks tighten a bit, but then USD weakness when they rewiden. The exception is the low-yielders (EUR, JPY, and CHF), which tend to weaken versus the USD in either breakevens scenario. As long as real yields are going up, these currencies should weaken. And with these three making up 75% of the DXY basket, this should support the DXY as well. The earlier-and-faster-taper scenario is even more USD positive. We expect 1.5% DXY gains per month and anticipate broad-based USD strength here as real yields rise, breakevens tighten, and markets price in (and then see realized) an accelerated taper followed by five rate hikes by end-2023 according to our economists. This is likely intuitive. Less intuitive, though, is the modest DXY strength (+20bp per month) we expect in a later-taper scenario. Isn't a taper delay dovish and thus USD negative? Not always. It's the context under which the Fed is delaying the tapering that matters, and in this scenario our economists have penciled in a meaningful slowdown in US (and thus likely global) data. Real yields likely fall, breakevens tighten, and this leads to USD strength across the board – except against JPY and CHF, which rise even more. So what gets the USD weaker? From a Fed-tapering perspective, that's a hard needle to thread. We would need to see not a reactive taper delay in response to soft data (in which Fed dovishness is insufficient to stem the tide of safe haven demand) but rather a proactive, prophylactic taper delay. We need to see real yields falling but breakevens widening, and wider breakevens would require Fed dovishness to overwhelm any data concerns. Given hawkish Fed rhetoric and robust US data, this doesn't seem the most likely outcome right now. Rather, USD weakness is more likely to come from abroad. A rebound in global data, particularly relative to rapidly decelerating expectations, would be USD negative, as would a hawkish pivot from major central banks like the ECB or PBoC. Barring that, we continue to envision USD strength, aided by Fed normalization. Our Current Stance On Markets In global rates markets, we continue to recommend UST 10y nominal rate shorts, EDZ2Z4 steepeners, short beta-weighted 10y breakevens (DV01 0.7:1), long 6m T-bills vs. OIS, and Z1/Z2 FRA/OIS flatteners. We recommend entering into 10s30s swap spread curve flatteners. In US rates vol, we continue to recommend structures that lean long vol and/or position for higher rates. In particular, we recommend 6m10y payer seagulls, selling 3m10s30s curve vol vs. buying 3m10y straddles, buying 3m5y payer condors, and maintaining any existing 1x2 6m5y payer spreads and 1x1 1y30y payer spreads. 8 In the euro area, we continue to recommend long 10y Bunds vs. short 10y UST, long 30y OATs vs. 30y Bunds, long Ireland 10y vs. short 10y OATs, and long 10y Italy vs. short 10y Spain. In Japan, we continue to recommend long 20y JGB ASW against TONA OIS or 3m DTIBOR, long 10y JGB ASW against 3m DTIBOR, paying 2y1y TONA OIS, paying 5y ZTIBOR-LIBOR basis, ZTIBOR-OIS 5s20s flatteners, 2s10s JPY basis steepeners, and paid positions in 10y10y JPY xccy basis. In the dollar bloc, we continue to recommend receiving the November RBNZ, ACGB 5s30s steepeners, and long BAZ2 futures positions. In foreign exchange markets, the USD has struggled to stay in a consistent market regime since the June FOMC. We think there's a risk that continues, though we think the most likely set of regimes for the USD to bounce between – a mix of Regimes 2 and 3 – are both negative for low-yielders. We remain bullish on the DXY and continue to see USD strength versus low-yielders and much of EMFX. We recommend entering into CAD/JPY longs (target 92.00, stop 85.50) and CHF/NOK shorts (target 9.1, stop 9.8). We continue to recommend AUD/NZD longs (target 1.08, stop 1.0350), USD/JPY longs (target 112.50, stop 108.40), and EUR/USD shorts (target 1.17, stop 1.2150). In the FX options space, we continue to suggest short 3m USD/JPY 112.5 call (priced 18-Jun-21) against the long delta position, and we recommend owning USD/CHF 1y risk reversal by buying a 0.9450 call and selling a 0.8850 put (priced 18June-21). 9 Interest Rate Strategy United States We suggest staying short 10y Treasuries, and maintaining EDZ2Z4 steepeners heading in to the FOMC minutes next week - as the tapering discussion comes to the fore. Additionally, our biotechnology analysts think that the daily cases in the US could peak in the next 1-2 weeks- which could further support risk sentiment, and higher yields. And finally, as we detail below, we fade the drop in the headline University of Michigan survey, and suggest focusing on the big picture from the survey's results - which is, in fact, supportive for higher yields. We look at how tapering impacts Treasury yields through two different channels (1) supply/demand channel and (2) signaling and forward guidance channel tapering on Treasury yields. We think the idea that Treasury's coupon cuts will offset the Fed's buying is a gross misunderstanding, that ignores the powerful signaling effect from tapering. In our base case, where the Fed announces tapering in December, we see 10y yields ending the year at 1.80%. The sharp decline in the University of Michigan consumer sentiment was likely driven by an "emotional reponse" to higher covid cases and higher inflation. While it may appear like a negative, we think investors should not miss the forest for the trees. From the Fed's perspective - the rise in inflation expectations, alongside the rise in NY Fed's inflation expectation survey, will keep the Fed nervous about inflation. On the other hand Powell has stated before does not see a major economic impact from the Delta variant, suggesting they too might read this decline in consumer sentiment as an "emotional response". On net, the University of Michigan survey is more likely to keep the Fed hawkish rather than dovish. Specifically, on the impact of Delta variant and how it affects the economy, we note that the recent rise in the Delta variant can have a longer term positive influence on the economy - in that it increases the speed to reach "herd immunity", and in very least, it means that the subsequent waves of covid cases will be shallower and have lesser economic impact. Euro area Following several quiet weeks, the market is likely to start positioning for a pickup in euro area issuance towards the end of the month. A large part of duration supply is likely to come via syndications, with the EU also resuming primary market activity for its NGEU programme. Still, given the ongoing ECB QE purchases at an elevated pace, as well as our economists' expectations for no taper in September, issuance net of QE and redemptions should remain negative for most European sovereigns, both in September and the remainder of the year. This supports our case for outperformance of European rates versus Treasuries in the weeks to come. 10 Japan Japanese investors currently look to be quite lightly positioned, having sold foreign bonds while yields were falling. It is worth asking whether Japanese investors might shift into dip-buying mode, now that US interest rates have started to head higher once again. We believe that only pension funds are likely to become potential buyers of USTs, contingent on a continued rally in foreign stocks and higher global yields. Lifers' activity in the foreign bonds space will likely be muted, given that fewer sales of insurance products owing to the Covid-19 outbreak have led to lower new money inflows for investment. We expect foreign equity or credit products to be prioritized over USTs as lifers look to get the best 'bang for their buck' from a yield perspective. What about banks? History suggests that banks have tended to lighten their positions as overseas interest rates have moved higher, while adding to their exposure when interest rates fall. Such behavior suggests to us that Japanese banks as a whole tend to view USTs less as a carry asset than as a potential source of capital gains. Based on past experience, we see little prospect of Japanese banks "bucking the trend" by buying on price dips as the UST market continues to price in a commencement of Fed tightening. We believe that Japanese banks are unlikely to become sizable dip-buyers until and unless they see clear signs that the Fed's tightening cycle is over (or, alternatively, that some major "risk off" event has forced the Fed to shelve its tightening plans for at least the time being). G10 G10 | More P1KEs and P0KEs We introduce P1KE and P0KE measures implied by OIS pricing for seven countries or entities (Japan, Euro Area, United Kingdom, Canada, Australia, New Zealand, and Sweden) and start daily updates to corresponding Bloomberg tickers. P0KE refers to the number of 25bp hikes implied by market pricing expected in the 12 months following the current date. P1KE refers to the number of 25bp hikes implied by market pricing expected in the 12 months following the date at which the market has priced in a full 25bp hike. P1KE indicates the speed at which the market expects a central bank to hike in the year after it lifts off (a date measured by our M1KE measures). 11 MORGAN STANLEY & CO. LLC United States | Stay short 10y Treasuries Guneet Dhingra, CFA Guneet.Dhingra@morganstanley.com +1 212 761-1445 Treasury yields moved sideways through much of the last week, holding the increase we saw following the solid July payroll report. A July core CPI print that disappointed consensus expectations, though it looked strong underneath (see United States | July CPI: strong under the hood) was unable to materially move Treasury yields. The sharp decline in consumer confidence on Friday ended up being the most influential datapoint for the week, with 10y yields declining ~5bp after the release (see Exhibit 15). As we discuss below, we suggest fading this latest decline in yields, ahead of the FOMC minutes. Exhibit 15: Moves in Treasury yields in August bp 13 15 10 6 5 0 9 8 -2 -5 -4 3 4 -1 -10 5y 10y 30y BE - Change from Jul 30 Nominal Change since Jul 30 Source: Bloomberg, Morgan Stanley Research RY - Change from Jul 30 Exhibit 16: Market implied end of tapering timeline Timing for end of tapering Jan-24 Oct-23 Jun-23 Mar-23 Dec-22 31-Aug-22 Aug-22 May-22 Feb-22 Dec-20 Feb-21 Apr-21 Jun-21 Aug-21 Market implied timing for end of tapering * We assume tapering ends 6months before the first rate hike Source: Bloomberg, Morgan Stanley Research The FOMC minutes will be a critical event next week, as markets will learn more about how the Fed is thinking about tapering – the timing (see Exhibit 16), the pace, and the mechanics. We think tapering is an important event for Treasury yields, and could add further impetus for higher yields (see How will tapering affect Treasuries?). The idea that Treasury's coupon cuts will offset the buying from the Fed grossly underestimates the forward guidance channel linked to tapering, which is the main channel which affects Treasury yields. We suggest staying short 10y Treasuries, and maintaining EDZ2Z4 steepeners heading into the FOMC minutes next week – as the tapering discussion comes to the fore. Additionally, our biotechnology analysts think that the daily cases in the US could peak in the next 1-2 weeks , which could further support risk sentiment and higher yields. And finally, as we detail below, we fade the drop in the headline University of Michigan survey and suggest focusing on the big picture from the survey's results – which is, in fact, supportive for higher yields. 12 University of Michigan survey – Don't miss the forest for the trees Consumer confidence tumbled in the latest University of Michigan survey – and as we noted in Are We Losing Confidence?, we see this as an aberration rather than a true reflection of economic sentiment. A combination of (1) the revival of COVID cases in the US, driven by the Delta variant, (2) and rising inflation likely played a part in lower confidence. As the commentary linked to the survey noted, there has been an "emotional response" by consumers to the resurgence of the pandemic. We think, investors focused too much on the headline might be missing the forest for the trees. University of Michigan survey official report: There is little doubt that the pandemic's resurgence due to the Delta variant has been met with a mixture of reason and emotion. Consumers have correctly reasoned that the economy's performance will be diminished over the next several months, but the extraordinary surge in negative economic assessments also reflects an emotional response, mainly from dashed hopes that the pandemic would soon end. For a start, it is important to think about how the Fed would interpret this latest decline in University of Michigan consumer confidence, driven by the resurgence of covid cases, and inflation. On the rise of the Delta variant, the Fed has already suggested it does not see major economic consequences from higher covid cases. On the other hand, the Fed has suggested that it would be watching carefully for a shift in medium-term inflation expectations – which have moved up. To that extent, if anything, the University of Michigan survey reading is more likely to make the Fed hawkish than dovish. Our chief US economist, Ellen Zentner, thinks the rise of the Delta variant or the decline in consumer confidence is unlikely to deter the Fed from continuing towards tapering. In a similar vein, we think investors should not be distracted by the decline in the headline numbers (the trees), and focus on two other dynamics that stem from the survey responses (the forest): (1) consumers' long-term inflation expectations are rising, and (2) the rise in covid-related distress in consumers could have some positive effects on the economy, in the long term (more on this below). Powell on the importance of inflation expectations: And if we were to see inflation moving up to levels persistently that were—that were above, significantly, materially above our goal and particularly if inflation expectations were to move up, we would use our tools to guide inflation back down to 2 percent. The rise in medium inflation expectations in the University of Michigan survey is an important datapoint to note, and it comes on the back of a yet another rise in the NY Fed survey for consumers' inflation expectations 3 years out (see Exhibit 17). At the July FOMC meeting (see grey box above), Fed chair Powell made it clear that the one datapoint that the Fed particularly cares about is the long-term inflation expectations, and the latest readings will not be giving the Fed any comfort. 13 Exhibit 17: Consumer survey measures of long-term inflation expectations over the last 20 years % % 3.8 3.4 3.6 3.4 3.2 3.2 3.0 3.0 2.8 2.8 2.6 2.6 2.4 2.2 2.4 2.0 2.2 Sep-01 May-03 Jan-05 Sep-06 May-08 Jan-10 Sep-11 May-13 Jan-15 Sep-16 May-18 Jan-20 5y Avg CPI Headline Source: Bloomberg, Morgan Stanley Research 5y5y U Mich While the rise of the Delta variant has affected consumer confidence for now, investors must consider what does it really mean for the economy? And for Treasury yields? As we noted last week, there are some positive medium-term influences that can emerge from the recent rise in covid cases. The fast rise of the Delta variant has meant that (1) more people who may have been hesitant about the vaccines have started getting the vaccines, and (2) more people who do not want to get vaccines (overlapping with lowrisk population cohorts) have acquired a natural immunity to covid via infection and subsequent recovery. As Exhibit 18 and Exhibit 19 show, covid cases have risen but with a much smaller impact on fatalities, while the rate of vaccination has improved in the US. Said differently, as a best case scenario, the rise of Delta-variant-driven cases can increase the speed to reach "herd immunity", and in the second best case, it means that the subsequent waves of covid cases will be shallower and have less economic impact. Exhibit 18: Daily covid cases in the US vs. daily covid-linked deaths 300,000 per 100,000 9 250,000 200,000 150,000 8 7 The vaccine effect 6 5 4 100,000 3 2 50,000 1 0 Jun-20 Dec-20 0 Jun-21 US -New cases -7-Day Moving Avg US -7-Day Death Rate per 100K Source: CDC, Morgan Stanley Research Exhibit 19: 7-day average pace of vaccinations in the US over the last six months 2,500 2,000 1,500 1,000 Increasing vaccinations 500 0 Jan-21 Mar-21 May-21 Jul-21 US -7-Day Avg People Receiving at Least 1 Dose Source: CDC, Morgan Stanley Research 14 Importantly, our biotech analysts think that covid cases in the US might be peaking in the coming two weeks, and thus we continue to think covid concerns, and their inflated impact on consumer sentiment is something investors should fade. Investors should focus on the upcoming information about tapering instead. How will tapering affect Treasuries? We think the tapering debate is likely to impact the US rates market through two different channels: (1) the direct impact will be based on how much can the taper timing, pace, or composition change the supply/demand dynamics for Treasuries, and (2) a second-order effect, where a formal kick-start to tapering can serve as a powerful form of forward guidance about the rate-hike cycle that lies ahead. We think the second channel is, by far, the more important. The supply/demand channel: Many investors look at tapering and think about the increase in Treasury supply when the Fed stops buying. In fact, many investors currently think about how Treasury coupon cuts, likely to start in November, will largely offset the impact of Fed's tapering, suggesting that tapering won't have any material impact from the supply/demand channel (see Exhibit 20). While this is true, the idea that a decrease in Treasury auctions sizes will neutralize the impact of tapering is a gross misunderstanding of how tapering could impact Treasuries, in our view. Investors should not get complacent about tapering being a "non-event". Exhibit 20: Treasury net issuance vs. Fed's QE purchases in 2021 and 2022 $bn 300 250 200 150 100 50 0 -50 -100 -150 Jan-21 Dec-21 Nov-22 Fed Purchases Net Notional Issuance Net Notional Issuance minus Fed purchases Source: US Treasury, Morgan Stanley Research Exhibit 21: Treasury net issuance vs. Fed's QE purchases in 2021 and 2022 (10y equivalents) $bn 350 300 250 200 150 100 50 0 -50 -100 Jan-21 Dec-21 Nov-22 Fed Purchases (10YE; duration of purchases ~6 years) Net Duration Issuance (10YE) Net Duration Issuance minus Fed purhases (10YE) Source: US Treasury, Morgan Stanley Research The real impact of tapering could play out via the forward guidance channel, with the supply/demand channel having a marginal effect. What does tapering tell us about when rate hikes will begin, and what is the pace at which the Fed will hike rates? 15 Recall that back in the summer of 2013, when yields rose sharply in the episode labeled as the "taper tantrum", 5y yields rose more than 30y yields, even though the Fed was significantly overweight 30y Treasuries in its QE program. This is because the market looked beyond the supply/demand change, and started pricing in rate hikes, leading to a bigger rise in 5y and 10y yields. Many studies on the effect of QE have concluded that QE served more as a forward guidance tool than a Treasury demand tool in its last few months in 2012 and 2013. So what could be the implied forward guidance via tapering in the coming months? The first aspect is the timing of the first rate hike. It is remarkable to us that this market implied timeline for the first hike (and implicitly, the timeline for tapering) has been in a tight range around 1Q23 over the last three months (see Exhibit 22). This suggests the timing of rate hikes (and tapering) are seen as widely expected and understood outcomes, with little variability. We think the main impact of tapering will be felt via how it impacts the market's implied pace of rate hikes, and that will decide the direction for yields. 10y yields have been strongly connected to the pace of hikes, and a faster pace of hikes will be consistent with higher 10y yields (see Exhibit 23). Exhibit 22: Market implied timing of the end of tapering Timing of the first rate hike Jul-24 Apr-24 Jan-24 Oct-23 Jun-23 25-Jan-23 Mar-23 Dec-22 Aug-22 Dec-20 Feb-21 Apr-21 Jun-21 Timing of first rate hike Source: Bloomberg, Morgan Stanley Research *We assume tapering ends about 6 moths before the first rate hike Aug-21 Exhibit 23: 10y yields vs. market implied pace of hikes # of 25bp hikes/12 months 10s 150 2.5 145 2.3 140 2.1 135 1.9 130 125 1.7 120 1.5 115 1.3 110 Jun-21 Jul-21 Jul-21 Jul-21 Jul-21 Aug-21 Pace after 1st hike (# of 25bp hikes) 10s Source: Bloomberg, Morgan Stanley Research We look at four scenarios for when, and how the Fed could start the tapering process, and how we think it could impact Treasury yields relative to our year-end forecast for 10y yields (currently at 1.80%). Even if the Fed tapers in line with our base case (end in November 2022), and behind the market implied timeline (end in July 2022), we think Treasury yields could rise. This is because tapering will "start the clock" on the exit policy, and the market will likely start repricing the implied pace of hikes closer to what the June dot plot suggests (6 members see at least 3 to 4 hikes a year, 2 members see 2, and 10 members' views unknown). To analyze these scenarios, we use our framework, which looks at 5y and 10y yields as a function of (1) the timing of the first hike, and (2) the implied pace of hikes (Exhibit 24). 16 In our base case, where our economists see tapering announced at the December FOMC meeting (starting in January 2022) and the first hike in 2Q23 – we think markets will price a pace of ~2.5 hikes, a conservative pace relative to the June dot plot. That repricing of the pace alone would push 10y Treasuries about ~25bp higher, closer to ~1.60% in the near term. Add to that our assessment that the passage of the infrastructure package is worth about ~20bp (for details, see here), we expect 10y yields to end the year at 1.80%. We show below how we think markets will reprice under other scenarios: MS base case: 10y yields end 2021 at 1.80%, as markets reprice to a faster pace at around 2.0-2.5 hikes. Real yields make up nearly 100% of the increase in yields. MS base case with faster MBS drawdown: 10y yields end at 1.80%, similar to our base case, as marginally faster MBS tapering does not affect the final timeline for ending tapering. Real yields make up nearly 100% of the increase in yields. Earlier and faster taper: 10y yields end 2021 at 2.10%, as markets reprice an even faster pace of hikes to around ~3 hikes a year, alongside an earlier start to rate hikes. Real yields rise more than nominals and breakevens decline. Later taper: 10y yields end 2021 at 1.40%, based on a further decline in the pace of hikes priced in, as well as a delayed start to rate hikes. Breakevens lead the decline, and real yields decline as well. Exhibit 24: 10y yields as a function of the timing and pace of rate hikes Timing of first hike 5s Pace of hikes (25bp/year) 10s Pace of hikes (25bp/year) 1.5 1.75 2 2.25 2.5 1.5 1.75 2 2.25 2.5 15-Sep-22 CMT rate (%) 0.85 0.91 0.97 1.03 1.09 1.30 1.39 1.48 1.56 1.65 vs. Market spot (bp) 0.02 0.08 0.14 0.20 0.25 -0.06 0.03 0.11 0.20 0.29 15-Dec-22 CMT rate (%) 0.77 0.83 0.89 0.95 1.00 1.24 1.33 1.42 1.50 1.59 vs. Market spot (bp) -0.06 0.00 0.06 0.11 0.17 -0.12 -0.03 0.06 0.14 0.23 30-Jan-23 CMT rate (%) 0.74 0.80 0.85 0.91 0.97 1.22 1.31 1.40 1.49 1.57 vs. Market spot (bp) -0.09 -0.04 0.02 0.08 0.14 -0.14 -0.05 0.04 0.13 0.21 15-Mar-23 CMT rate (%) 0.71 0.77 0.83 0.88 0.94 1.21 1.30 1.39 1.48 1.56 vs. Market spot (bp) -0.12 -0.06 -0.01 0.05 0.11 -0.15 -0.06 0.03 0.12 0.20 30-Apr-23 CMT rate (%) 0.69 0.75 0.80 0.86 0.92 1.21 1.30 1.38 1.47 1.56 vs. Market spot (bp) -0.14 -0.09 -0.03 0.03 0.09 -0.15 -0.06 0.02 0.11 0.20 15-Jun-23 CMT rate (%) 0.67 0.73 0.79 0.85 0.90 1.21 1.30 1.39 1.48 1.57 vs. Market spot (bp) -0.16 -0.10 -0.04 0.01 0.07 -0.15 -0.06 0.03 0.12 0.21 Source: Bloomberg, Morgan Stanley Research Trade idea: Maintain short 10y UST at 128bp Trade idea: Maintain EDZ2Z4 steepeners at 91bp 17 Euro area | September issuance preview MORGAN STANLEY & CO. INTERNATIONAL PLC Alina Zaytseva Alina.Zaytseva@morganstanley.com Lorenzo Testa Lorenzo.Testa@morganstanley.com +44 20 7677-1120 +44 20 7677-0337 Ongoing ECB accommodation is set to limit supply pressures in September Following several quiet weeks, the market is likely to start positioning for a pick-up in euro area issuance towards the end of the month. A large part of duration supply is likely to come via syndications, with the EU also resuming the primary market activity for its NGEU programme. Still, given the ongoing ECB QE purchases at an elevated pace, as well as our economists' expectations for no taper in September (see ECB Reaction | See you in September), issuance net of QE and redemptions should remain negative for most European sovereigns, both in September and the remainder of the year. This supports our case for outperformance of European rates versus Treasuries in the weeks to come. Funding progress update – entering the final stretch Most countries have now completed 60-70% of their issuance targets for 2021. Belgium and Portugal lead the funding progress ranking, with both completing over 80% of their full-year target. This implies that the required funds may be raised within the standard auction schedule, without additional syndications. Exhibit 25: Estimated funding progress as of August 13, 2021 2021 issuance projection Issued through Aug Issuance Remaining, Issued through Aug 13, €bn € bn 13, % of Expected Austria 45 29 16 64% Belgium 36 30 6 84% Finland 18 10 8 58% France 290 206 84 71% Germany 246 158 88 64% Ireland 20 15 5 74% Italy 350 231 119 66% Netherlands 55 35 20 64% Portugal 15 13 Spain 163 120 2 87% 43 73% Source: Morgan Stanley Research estimates Exhibit 26: September issuance net of QE and redemptions – 2021e versus previous years €, bn 20 15 10 5 0 -5 -10 -15 -20 -25 -30 GE FR IT SP AS BE FI IR NE PO 2020 2021 2015 - 2019 avg Source: Morgan Stanley Research estimates September outlook – syndications to contribute the most to duration supply Overall, our September issuance estimates suggest that the supply numbers are likely to be in line with or just below 2020 levels and significantly above longer-term averages, which is consistent with the issuance patterns earlier in 2021. The same applies to our issuance estimates in 10-year equivalent (10YE) terms, where the timing and maturity of potential syndications would be key for what an issuer's profile looks like for the month (see Exhibit 27 and Exhibit 28). 18 Based on the historical patterns, Finland is very likely to kick off the upcoming round of syndications in the last week of August (see Exhibit 29). The issuers that are likely to conduct syndications in September include: Germany: The DFA has announced its plans to issue a new 30y DBR via syndication in September, where we are looking for ~€6 billion size. Spain: The Spanish Treasury has announced its plans to issue the inaugural green Bono in 2H21. The Spanish offering is expected to have a 20y maturity and is likely to match the success of the debut Italian ESG offering earlier this year. Italy: Historically, October appears a more likely month for a BTP syndication, but in 2020 the Italian Treasury chose to conduct an offering in early September. Given the generally favorable market environment and BTP-Bund spread hovering around 100bp, it may choose to do the same this year. Notably, even if Italy chooses to conduct the syndication in September, the country's issuance is set to be deeply negative in September, given the high volume of redemptions and the ECB continuing to conduct PEPP purchases at an elevated pace through the month (see Exhibit 26). In addition, the Netherlands will offer a new 2029 maturity DSL in September. Elsewhere, Austria and Ireland are the possible candidates to conduct a syndication in October, we think. Austria may also continue fulfilling a part of its remit via private placements Exhibit 27: Estimated September issuance – 2021e and previous years €, bn 35 30 25 20 15 10 5 0 AS BE FI FR GE IR IT NE PO SP 2015-2019 avg 2020 2021e Source: Morgan Stanley Research estimates Exhibit 28: Estimated September issuance in 10-year equivalent terms – 2021e and previous years €, bn 40 35 30 25 20 15 10 5 0 AS BE FI FR GE IR IT NE PO SP 2015-2019 avg 2020 2021e Source: Morgan Stanley Research estimates Weekly 10YE supply should stay below 2021 average during most weeks The 1Q21 flurry of long and ultra-long-end issuance brought the average 2021 weekly 10YE supply to elevated levels (see Euro area | 5s30s steeper everywhere as long-end supply weighs, February 13, 2021). Therefore, despite the fact that most of the anticipated syndications are expected (or confirmed, as in the case of Germany) to be in the 20-30y maturity bucket, weekly 10YE supply should stay below this year's averages, with the exact numbers depending on the timing of syndications (see Exhibit 30). 19 Exhibit 29: Count of syndications in August-October between 2013 and 2020 9 8 7 6 5 4 3 2 1 0 FRA BEL AUT ITA IRE SPA FIN POR NETH GER August September October Source: Morgan Stanley Research estimates Exhibit 30: Estimated weekly 10YE supply €, bn 50 45 40 35 30 25 20 15 10 5 0 30-Aug 06-Sep 13-Sep GER FRA ITA AUT BEL FIN Source: Morgan Stanley Research estimates YTD average = €32.5bn 20-Sep 27-Sep SPA NETH POR IRE 4Q21 issuance – risks of downside remit revisions? Funding progress and year-to-date budget performance suggest that, in the absence of additional meaningful restrictions on economic activity as a result of the Delta variant spread, the risks to the current full-year supply projections continue to be to the downside. Last month, Spain decreased its full-year funding requirement by €20 billion, with the reduction evenly split between bills and longer-term bonds. The Italian Treasury also cancelled two supply events in July and August, citing its favorable cash position. Exhibit 31: Government cash balances in June 2021 versus the 2019 average €, bn 140 120 100 80 60 40 20 0 AS BE FI FR GE IR IT NE PO SP 2019 avg Jun-21 Source: ECB, Haver Analytics Exhibit 32: Government cash balance evolution in EA4 €, bn 250 200 150 100 50 0 Jan-19 Jul-19 GE Source: ECB, Haver Analytics Jan-20 FR Jul-20 IT Jan-21 SP 20 The latest available data point to Treasury cash balances remaining above long-term averages for most euro area sovereigns (see Exhibit 31 and Exhibit 32). Therefore, similarly to in Germany and France earlier in 2021, the governments may choose to use surplus cash to fund parts of the remaining planned expenditure for the year. The remit reductions may start trickling in together with the publications of 4Q supply outlooks over the second half of September. Strong Treasury cash positions may also have implications for 2022 issuance plans, reducing the need for new bond issuance and relieving some of the pressure the market may face ahead of the potential ECB taper. Trade idea: Maintain long 10y Germany vs. UST Trade idea: Maintain long 10y Italy vs. Spain Trade idea: Maintain long 30y France vs. Germany Japan | Will Japanese investors buy USTs in the current sell-off? MORGAN STANLEY MUFG SECURITIES CO., LTD. Koichi Sugisaki Koichi.Sugisaki@morganstanleymufg.com Shoki Omori Shoki.Omori@morganstanleymufg.com +81 3 6836-8428 +81 3 6836-5466 UST yields have risen in the wake of the July Employment Situation report, which market participants have interpreted as giving the Fed a green light to announce advance notice for tapering. As discussed in "Focus on the carry sector", Japanese investors currently look to be quite lightly positioned, having sold foreign bonds while yields were falling. It is thus worth asking whether Japanese investors might shift into dip-buying mode, now that US interest rates have started to head higher once again. This is in fact quite an important question given that selling by Japanese investors appears to have exacerbated the rise in UST yields seen at the start of 2021 (see Is owning Treasuries a good risk-off hedge again?). Less new money, less investment Life insurers have remained net sellers of foreign bonds to this point (see Exhibit 33). As explained in Has demand for super-long JGBs weakened among life insurers?, we attribute this to a combination of (1) new money inflows having dwindled as face-to-face policy sales have been impacted by the pandemic, and (2) JPY duration having been made the top priority as lifers continue their preparations for Japan's 2025 adoption of an economic-value-based solvency regime. 21 Risk taking might be somewhat easier going forward now that regulatory positioning has been substantially completed, but nevertheless we expect that falling levels of new money inflows will limit dip-buying demand for USTs even if yields continue to improve (see Exhibit 34). Indeed, we expect foreign equity or credit products to be prioritized over Treasuries as lifers look to get the best 'bang for their buck' from a yield perspective. Exhibit 33: Net purchase of foreign long-term debt securities by Japanese lifers Exhibit 34: Lifers' potential new money to be invested (premium income-annuity & benefits-surrender value) Source: Japan Mof, Morgan Stanley Research Source: Morgan Stanley Life, The Life Insurance Association of Japan No significant rebalancing to foreign bonds now, but pension funds may prefer USTs over EGBs Pension funds were quite big buyers of foreign bonds through FY2020, with rises in overseas interest rates and stock prices necessitating a rebalancing out of foreign equities into foreign bonds (see Exhibit 35). However, as discussed in JPY | Potential ramifications of public pension portfolio rebalancing for JPY cross-rates the pension system's portfolio weight of foreign bonds should now be quite close to its target range midpoint (i.e. neutral), suggesting that additional allocations to this asset class will be limited in the absence of significant mark-to-market fluctuations. At this point in time, we think rebalancing is likely to entail mostly a shift out of foreign equities into domestic equities. That said, with foreign stock prices continuing to exhibit upward momentum, it is possible that pension funds will need to shift out of foreign equities into foreign bonds if overseas interest rates should keep rising. We would then expect to see sizable flows into the UST market by virtue of its large market cap. 22 As was reported in the media, in FY2020 the Government Pension Investment Fund overweighted European bonds rather than USTs (see Exhibit 36). Passive investment accounts for roughly three-quarters of the GPIF's foreign bond portfolio, with weights determined mostly by market capitalization. That said, even some passive managers use benchmark indices that invest solely in (say) US or European bonds, meaning that it is possible to invest comparatively heavily in the sovereign debt of a particular nation. Moreover, the active managers responsible for the remaining one quarter of the GPIF's foreign bond portfolio are obviously allowed to skew their allocations in the hope of outperforming their benchmarks. Exhibit 35: Net purchase of each asset class by trust accounts Exhibit 36: GPIF's government bonds holdings by region USD bn 180 160 140 120 100 80 60 40 20 0 US FR IT ES DE GB BE NL CA AU FY2020 FY2019 Source: GPIF website, Morgan Stanley Research Source: Morgan Stanley Research, Macrobond However, overweighting of European sovereigns in 2020 is likely to have reflected their view that the US dollar would weaken as a consequence of the Fed's ultra-aggressive monetary easing. This year the GPIF's portfolio managers might be more inclined to overweight USTs, with the greenback perhaps looking relatively attractive as the ECB maintains a dovish stance in the wake of its strategy review whereas the Fed is turning more hawkish in response to stronger-than-expected inflation and improving labor market conditions. Within the foreign bonds space, we believe that they will focus more on USTs than EGBs this year, particularly if the dollar should strengthen against the yen as US interest rates keep climbing. Japanese banks are unlikely to be UST dip-buyers What about banks? MoF International Transactions in Securities data do show the banking sector making almost ¥2 trillion in net purchases of foreign bonds for June, but this was followed by a ¥2.2 trillion net selloff in July as overseas interest rates moved lower. The banking sector's trading in foreign bonds has historically exhibited quite strong correlation with Japanese investors' net purchases of US sovereign bonds (see Exhibit 37), which suggests to us that banks are likely to have taken a UST-centric approach to their buying and selling over the past couple of months. Put simply, we believe that some positions entered in June may have been quickly exited (at a profit) as the UST market rallied in July. 23 Such behavior would however be at odds with historical patterns, with data for the past decade or so actually revealing the banking sector to be more of a trend-follower than a contrarian (see Exhibit 38). In other words, banks have tended to lighten their positions as overseas interest rates have moved higher while adding to their exposure when interest rates fall. Exhibit 37: Net purchase of US sovereign bonds by Japanese investors vs. net purchase of foreign bonds by Japanese banks Exhibit 38: Cumulative net purchase of foreign bonds by Japanese banks (since 2013) vs 10y UST yield Source: Japan Mof, BoJ, Morgan Stanley Research Source: Japan Mof, BoJ, Morgan Stanley Research We also note with some interest—after taking funding costs into account—that banks have generally been net buyers of foreign bonds (presumably mostly USTs) even when carry is negative (such as was the case from 2019 through 1H 2020) (see Exhibit 39). Such behavior suggests to us that Japanese banks as a whole tend to view USTs less as a carry asset than as a potential source of capital gains. Exhibit 39: Cumulative net purchase of foreign bonds by Japanese banks (since 2013) vs 10y UST yield - 3m repo rate Exhibit 40: Domestic banks' major profit source Source: Japan Mof, BoJ, Morgan Stanley Research Source: Japanese Bankers Association, Morgan Stanley Research 24 The banking sector has indeed recently been struggling with a decline in net interest income (see Focus on the carry sector), and is perhaps looking to support its bottom line by selling off strategic stockholdings while also locking in capital gains on sovereign bonds (see Exhibit 40). Indeed, our impression is that bond trading is now being given a higher priority amid expectations that the COVID-19 crisis is liable to keep depressing global interest rates for quite some time to come. From a trading perspective banks are likely to be less interested in current UST yield levels than in the potential for yields to stop rising and then start falling once again. The banking sector is probably looking for interest rates to move gradually higher over the next few years given that strong US inflation and a recovering labor market have seemingly made it more likely that the Fed will shift into tightening mode, and last month's net selloff of foreign bonds into the strength appears to have reflected an assessment that rising UST prices were ultimately little more than a temporary "summer rally". As such, we believe that Japanese banks are unlikely to become sizable dip-buyers until and unless they see clear signs that the Fed's tightening cycle is over (or, alternatively, that some major "risk off" event has forced the Fed to shelve its tightening plans for at least the time being). The banking sector in fact continued to sell off foreign bonds throughout the Fed's previous tightening cycle, which only came to an end in 2019 as an escalation of USChina trade dented confidence in a strong economy (see Exhibit 37). At the very least, based on past experience we see little prospect of Japanese banks "bucking the trend" by buying on price dips as the UST market continues to price in a commencement of Fed tightening. Exhibit 41: Domestic banks' main asset class Exhibit 42: Potential investment demand to avoid negative interest changes on BoJ current account balances(city banks' data ) Source: BoJ, Morgan Stanley Research Source: BoJ, Morgan Stanley Research 25 MORGAN STANLEY & CO. LLC Those looking to buy into weakness for carry-generating purposes are likely to favor either super-long USTs (in anticipation of a lower long-run neutral rate vs the current dot plot estimation) or European bonds (with the recent conclusion of the ECB's strategy review suggesting that policy tightening is unlikely any time soon). Banks might also look to park surplus funds in JGBs as their JPY-denominated deposits continue to grow strongly due to the combined impact of BoJ quantitative easing and an increase in ordinary deposits owing to significant fiscal spending (see Exhibit 41). We still expect this sort of demand –motivated by a desire to "avoid" negative interest rates –to support outperformance of 10y and 20y JGBs versus swaps as overseas interest rates continue to move higher (see Exhibit 42). Trade idea: Maintain long 10y JGB ASW against 3m DTIBOR Trade idea: Maintain long 20y JGB ASW against 3m DTIBOR or TONA OIS Trade idea: Maintain Pay 2y1y TONA OIS G10 | More P1KEs and P0KEs Andrew Watrous Andrew.Watrous@morganstanley.com David S. Adams, CFA David.S.Adams@morganstanley.com +1 212 761-5287 +1 212 761-1481 Measures of P0KE (the number of 25bp rate hikes the market prices in over the forward 12-month period) and P1KE (the market-implied pace of hikes after 1st rate hike) have long been cornerstones of the US rates strategy team's analysis of the Treasury market. More precisely, P0KE refers to the number of 25bp hikes implied by market pricing expected in the 12 months following the current date. P1KE refers to the number of 25bp hikes implied by market pricing expected in the 12 months following the date at which the market has priced in a full 25bp hike. In other words, how fast does the market expect a central bank to hike in the year after it lifts off (a date measured by M1KE - see (How) Many M1KEs)? We introduce similar measures implied by OIS pricing for seven countries or entites (Japan, Euro Area, United Kingdom, Canada, Australia, New Zealand, and Sweden). P0KEs for those countries are published daily on Bloomberg at the following tickers: MSP0KEJP, MSP0KEEU, MSP0KEUK, MSP0KECA, MSP0KEAU, MSP0KENZ, MSP0KESK. The charts below reveal P0KE's utility. While expected hikes have only started to roll into the 12-month window for certain G10 countries (particularly New Zealand, the UK and Canada), Exhibit 43 and Exhibit 44 (smoothed for clarity of presentation) show the period during 4Q 2020 during which markets expected roughly two 25bp cuts below zero from the RBNZ. 26 Exhibit 43: G10 P0KEs... Exhibit 44: ...smoothed Source: Bloomberg, Morgan Stanley Research Source: Bloomberg, Morgan Stanley Research P1KEs are published daily on Bloomberg at the following tickers: MSP0KEJP, MSP0KEEU, MSP0KEUK, MSP0KECA, MSP0KEAU, MSP0KENZ, MSP0KESK. P1KE measures are generally more volatile than P0KE and M1KE measures due to declining liquidity further out than 18 months on most OIS curves. For example, STIBOR swap data has only recently allowed calculation of a P1KE measure for Sweden. Exhibit 45: G10 P1KEs... Exhibit 46: ...smoothed Source: Bloomberg, Morgan Stanley Research Source: Bloomberg, Morgan Stanley Research We intend to use these P1KE and P0KE metrics frequently in the coming months and years as the basis of our rates and FX analysis. Two related notes: 1. We expect that (while far off) once the ECB delivers a future hike, the size of that hike will be 25bp rather than 10bp. We therefore adjust our M1KE measure for the Euro Area (MSM1KEEU Index) to reflect the number of months until the market has priced a full 25bp hike (rather than 10bp previously). 27 2. Once a central bank delivers an initial hike, we intend to stop publishing M1KE (months to 1st rate hike) and P1KE (pace of hikes following the 1st rate hike). If the RBNZ hikes next week (as we expect; see NZD | RBNZ preview: A dovish liftoff), we will cease daily updates to MSM1KENZ Index and MSP1KENZ Index). 28 Currency & Foreign Exchange United States USD | Trading Fed tapering We examine how the USD would respond under various hypothetical tapering scenarios from the Fed. Morgan Stanley's base case is that the Fed formally announces tapering in December 2021 and slows purchases gradually over 12 months. This is likely to see modest USD strength – DXY gains of about 50bp per month – as real yields rise, but breakevevns are comparatively little changed, which should generate mixed results for most currency pairs but more consistent USD gains versus low-yielders such as JPY, CHF, and EUR. Thus in this scenario, USD strength would be most concentrated versus lowyielders, supporting the DXY relative to the Fed Broad USD. A similar scenario where the Fed tapers MBS faster than Treasuries, but otherwise the economic outlook is the same is likely to generate a similar USD response – DXY gains of roughly 50bp/month. An earlier-/faster-taper scenario likely sees meaningful USD strength, with DXY gains of roughly 150bp/month. This scenario sees much more accelerated labor market tightening and higher inflation, forcing the Fed to not only accelerate its tapering but also hike 5 times by end-2023. This puts us in Regime 3 – with higher real yields, tighter breakevens, and broad-based USD appreciation. A later taper, perhaps counterintuitively, we think probably wouldn't be USDnegative though. This is because the state of the world generating this later-taper scenario is one in which US and global data are softer, pushing real yields and breakevens both lower. This puts us in Regime 4, which sees safe haven currencies such as JPY and CHF outperforming and USD gaining versus risk-sensitive currencies. Thus we see DXY strength of about 20bp per month. What gets the USD weaker? From a Fed perspective, we think this is a tough needle to thread. The Fed would have to turn more dovish but proactively dovish, not simply reacting to a worsening outlook. Given recent Fedspeak and incoming US data, this seems relatively implausible. A more likely candidate for USD weakness would come from abroad, such as improving global data or foreign central banks turning more hawkish. 29 Europe CHF | Selling CHF/NOK CHF has caught investors’ attention as it was the strongest G10 currency in July even despite EUR/USD trading stable. The Swiss National Bank (SNB) did not intervene in FX markets while EUR/CHF was breaking below key levels, but it may have returned to the markets last week. In our view, the EUR/CHF weakness was driven mainly by the fall in global bond yields, and the SNB could have stayed on the sidelines as equity and FX market volatility remained low. Given that we expect US real yields to rise from here, USD/CHF and EUR/CHF should see gains. The upside for EUR/CHF, however, may be limited by the dovish ECB keeping German yields low. Positioning also favours a weaker CHF, as shortterm investors had been buying CHF in recent weeks. We suggest selling CHF/NOK on the back of our expectation for a steeper US 2s10s curve, monetary policy divergence, NOK trading cheap versus oil prices, and cleaner positioning in both CHF and NOK. We also stay long USD/CHF via 1y risk reversal. Dollar Bloc NZD | RBNZ preview: A dovish liftoff We expect the RBNZ to hike rates 25bp at its upcoming August meeting. We're skeptical of a 50bp liftoff as investors are increasingly discussing and pricing. The NZ economy is running hot, but our shadow short rates imply that nearly 100bp of tightening has taken place since mid-June alone and the SSR is at 12 month highs A 50bp rate hike would be a strong signal to the market that the RBNZ feels behind the curve, which would generate 1) more term premium for 50bp subsequent rate hikes; 2) a faster pace of tightening priced in; and 3) a terminal rate above neutral. This change in pricing would overly tighten financial conditions and would, we think, run counter to the RBNZ's aims. Thus we expect markets to view this as a "dovish liftoff". As a result we remain long AUD/NZD and received the November RBNZ meeting. CAD | Inching back into CAD longs In recent weeks, investors have reduced net long CAD positioning, and a key trader survey suggests that bearish CAD sentiment has reached stretched levels. BoC expectations have also adjusted closer to levels we consider fair. Finally, the recent rise in USD/CAD has lifted it to levels inconsistent with current oil prices and short-term interest rate differentials. For all of the above reasons, we think the time is right to enter long CAD positions. However, given our expectation for continued USD gains as the Fed tapers its asset purchases later this year, we recommending long CAD against currencies that typically weaken when US real rates rise. Given how CAD has previously traded during episodes when US real rates were rising, we expect CAD gains to be most pronounced against low yielding currencies like JPY and SEK. We therefore recommend investors enter long CAD/JPY positions targeting 92.00. If CAD/JPY were to fall to 85.50, we suggest exiting the trade and reassessing the CAD outlook. 30 Japan JPY | Potential ramifications of public pension portfolio rebalancing for JPY crossrates We discuss the reason for the recent relative underperformance of CCY/JPY versus cyclical stock performance. While such underperformance might be a reflection of overseas investors having already shorted the yen quite heavily, another possibility is that Japan's public pension system has been rebalancing its portfolio out of foreign equities into domestic stocks. Indeed, Mof data show trust accounts (on behalf of pension funds ) having sold off foreign equities to the tune of over ¥1.1 trillion in July, while net purchases of foreign bonds were quite limited. Our estimation suggests that the public pension system is currently still a little overweight foreign equities and underweight domestic equities, suggesting that such rebalancing flows could continue for at least the time being. That said, once such rebalancing demand is satisfied, we still expect yen cross-rates to rally along with a rise in cyclical stocks as the concerns about the economic slowdown on the back of the Delta variant outbreak are alleviated. We continue to favor USD/JPY longs from a risk/reward perspective. USD/JPY could be expected to hold up comparatively well, with the greenback also having a "funding currency" aspect and as such unlikely to underperform JPY all that dramatically if sentiment should end up shifting back into "risk off" mode (which should be supportive for both USD and JPY). G10 FX Trades Exhibit 47: G10 FX trade ideas Spot trades Spot Target Stop Enter Short CHF/NOK 9.596 9.100 5.2% 9.800 Long CAD/JPY 87.66 92.00 4.9% 85.50 Maintain Long AUD/NZD 1.0472 1.0800 3.1% 1.0350 Short EUR/USD 1.1801 1.1700 0.9% 1.2150 Long USD/JPY 109.66 112.50 2.6% 108.40 Options trades Entry/cost/premium received Maintain Short 3m USD/JPY 112.50 call to receive 0.40% (priced on 18-Jun-21) Long USD/CHF 1y risk reversal, buy 0.9450 call, sell 0.8850 put to receive 0.21% (priced on 18-Jun-21) Source: Bloomberg, Morgan Stanley Research -2.1% -2.5% -1.2% -3.0% -1.1% 31 MORGAN STANLEY & CO. LLC USD | Trading Fed tapering David S. Adams, CFA David.S.Adams@morganstanley.com Andrew Watrous Andrew.Watrous@morganstanley.com +1 212 761-1481 +1 212 761-5287 This note is a summary of our scenario analysis on Fed tapering. See here for the full note: US Economics & Global Macro Strategy: Trading the Taper (13 Aug 2021) At face value, the USD impact of different tapering scenarios appears straightforward: earlier and faster tapering is hawkish and thus USD-positive; slower and later tapering is dovish and thus USD-negative. We don't disagree with this framework, although we think slightly more nuance is required. Exhibit 48: Impact of different taper scenarios across asset classes Scenario Announce Rough Pace 10y yields YE target 10y real yields YE target 5s30s curve Base Scenario Dec 2021 Faster MBS Dec 2021 Earlier/Faster Taper Nov 2021 Tsy: $10bn/ meeting ; MBS 1.80% $5bn/meeting Variable; Starting with $10bn/ month 1.80% in both Tsy and MBS Tsy: $10bn/ month ; MBS 2.10% $5bn/ month Later Taper Jun 2022 Tsy: $10bn/ meeting ; MBS 1.40% $5bn/ meeting -0.60% 100bp -0.60% 100bp -0.20% 80bp -1.00% 140bp Source: Morgan Stanley Research estimates MBS Credit FX S&P Year-End Targets CC nominal spreads 10bp tighter, OAS 5bp tighter Credit spreads widen to touch our 2Q22 targets of DXY +50b/ 105bp in IG and 320bp in HY mo before year-end 3900 CC nominal spreads 15bp wider, OAS 20bp wider Credit spreads widen to touch our 2Q22 targets of DXY +50b/ 105bp in IG and 320bp in HY mo before year-end 3900 CC nominal spreads Loans > HY > IG 20bp wider, OAS 10bp performance order is re- wider established. DXY +150bp/ mo 3750 CC nominal spreads widen out 10bp initally but tighten back 5bp Loans and HY underperform IG; spread weakness more concentrated in lowerquality cyclicals DXY + 20bp/ month 3250, assuming delay is due to growth disappointment Our USD framework uses the performance of real yields and breakevens to evaluate USD's performance based on the four possible outcomes; real yields rising or falling, breakevens widening or tightening. Each of these four USD regimes offers different results, summarized in Exhibit 49. All in, we expect USD's reaction in each of the four scenarios to be: Morgan Stanley base case: USD stronger versus low-yielders, DXY gains 50bp/mo (Regime 2/3) as real yields rise but breakevens are little changed, so we straddle Regimes 2 and 3. USD gains are most concentrated versus low-yielding funders while risk currency performance is likely muted. Earlier/faster taper: USD broadly stronger, DXY gains 150bp/mo (Regime 3) as real yields rise meaningfully (+45bp) and breakevens tighten as markets price in an earlier-than-expected rate hike. Faster MBS taper: USD stronger versus low-yielders, DXY gains 50bp/mo (Regime 2/3) as FX responds in a similar manner to our base case economic scenario based on how real yields and breakevens respond. 32 Later taper: USD gains except versus safe havens, DXY gains 20bp/mo (Regime 4) as real yields fall and breakevens tighten as a state of the world with a delayed tapering is also one where risk likely softens and safe havens gain. Exhibit 49: Morgan Stanley's USD-real yield framework Regime 1 Regime 2 Regime 3 Regime 4 Real Yields ↓ Breakevens ↑ Real Yields ↑ Breakevens ↑ Real Yields ↑ Breakevens ↓ Real Yields ↓ Breakevens ↓ DXY -125bp/month DXY +21bp/month USD Performance DXY +20bp/month DXY +75bp/month USD universally weaker USD mixed; stronger against low yielders, weaker against high risk FX USD universally stronger USD modestly stronger, weaker against safe havens Best FX Trades Short USD vs. AUD, NZD, NOK Long CAD, NZD, RUB, BRL vs. JPY Long USD vs. AUD, NOK, EM FX Long CHF, JPY vs. Commodity FX Source: Morgan Stanley Research Base taper scenario: USD stronger versus low-yielders, DXY likely gains roughly 50bp per month. Our economists' base case represents a challenging case for the USD. Our rates colleagues expect it to generate higher US nominal yields and real yields, but breakevens are likely to be little changed given that this base case is likely pretty close to market consensus. The two regimes that see real yields rising are Regime 2 (higher real yields, wider breakevens) and Regime 3 (higher real yields, tighter breakevens). Regime 3 tends to see universal USD strength. Regime 2 is a bit trickier; the USD tends to be mixed, weakening versus risk-sensitive currencies such as AUD, but gaining versus low-yielding funders such as JPY, CHF, and to a lesser extent EUR. This is why in Regime 2 we tend to see positive DXY performance (75% of the DXY basket is EUR, JPY, and CHF) on average, but the Fed Broad USD, which is more biased toward risk currencies, tends to be unchanged on net. Exhibit 50: USD performance in Regimes 2 and 3 tends to be mixed except for low-yielders, which consistently weaken 250 Average monthly change, USD v CCY under real yield and breakevens outcomes (bp) 200 150 Regime 3 100 50 0 -50 Regime 2 -100 ↓ = USD Weakness AUD NZD BRL NOK CAD SEK ZAR RUB EUR DXY CHF GBP USD JPY IDR INR MXN Regime 2 (Real Yields ↑, Breakevens ↑) Regime 3 (Real Yields ↑, Breakevens ↓) Source: Bloomberg, Morgan Stanley Research Exhibit 51: Global PMIs are showing increasing signs of rolling over 100% Global Manufacturing PMIs 60 80% 60% 55 40% 20% 50 0% -20% 45 -40% -60% 40 -80% -100% 35 Jan Mar May Jul Sep Nov Jan Mar May Jul 2020 2020 2020 2020 2020 2020 2021 2021 2021 2021 % of PMIs Decreasing % of PMIs Increasing Global PMI (RHS) Source: Markit, Haver Analytics, Morgan Stanley Research 33 We think this tapering scenario is likely to see markets straddling these two regimes, perhaps bouncing around between them. This switch back and forth means that, for most currency pairs, the USD is probably rangebound on net. The exception is the lowyielding funders, which weaken in both Regimes 2 and 3. For this reason, we concentrate our USD bullishness on these low yielders, which are most sensitive to rising real yields (Exhibit 50). On average, the DXY gains 20bp per month in Regime 2 and 75bp in Regime 3. If we assume we spend a roughly equal time in Regimes 2 and 3, then we would expect to see the DXY's performance in between these expected performances – giving us roughly 50bp per month in gains. Earlier/faster taper scenario: USD broadly stronger, DXY gains 150bp per month. This taper scenario likely puts us firmly in Regime 3 of our framework – higher real yields, tighter breakevens, and broad-based USD gains. On average, the DXY gains 75bp and the Fed Broad USD tends to gain 83bp per month in this market regime. Ultimately, though, we think upside risks to the USD are greater in this particular scenario than the average, and thus we think 1.5% gains per month are very plausible. This is because of the particular market context in which this taper scenario would take place. A faster tapering and a multitude of assumed rate hikes in this scenario (bringing fed funds up to 1.375% by end-2023), coupled with very robust US data, would contrast quite meaningfully with data in other economies and global central banks. While the Fed normalizes at an increasingly fast pace, the ECB and PBoC are likely to be turning more dovish in 2021, not less dovish. Indeed global PMIs are showing increasing signs of rolling over (Exhibit 51). Outright policy divergence where policymakers are moving in opposite directions (not just the same direction at different relative paces) tends to generate more meaningful currency moves. Faster MBS taper: USD stronger versus low-yielders, DXY likely gains roughly 50bp per month. Ultimately we think this MBS-taper scenario would have a similar FX impact as our base case tapering scenario would, straddling Regimes 2 and 3 and thus generating a roughly 50bp/mo DXY-positive impetus. To this end, we pencil in a similar expectation for the USD's reaction as we do in our base case scenario. Later taper: USD stronger except versus safe havens, DXY gains 20bp/mo. This reaction might seem counterintuitive. After all, a taper later than market expectations is dovish, and generally speaking central bank dovishness is currency-negative all else equal. The problem is that a state of the world in which we generate a later-than-expected taper is one in which data in the US – and thus likely also globally, given the US's economic size – is much softer than expected. Indeed, the economic scenario our economists describe is one where labor market tightening and inflation both stall, keeping the FOMC further from its goals of an inflation overshoot and pre-COVID labor market tightness. 34 This data-negative world likely sees real rates and breakevens both falling as markets are forced to price in a softer outlook. This is Regime 4 of our framework, which tends to see modest USD strength at the index level – 20bp per month for the DXY – but differentiated performance, in which USD gains versus most currencies but weakens noticeably versus JPY and CHF. This is why the Fed Broad USD tends to gain more than the DXY (36bp on average). Thus, just like how the best FX trades in Regime 2 are cross trades, the same is true for Regime 4. For the later taper risk-off scenario, one should buy safe havens such as CHF and JPY versus higher-beta currencies such as AUD, CAD, and EMs. Sequencing is important, though. The decline in nominal and real yields and breakevens probably doesn't last forever. Our rates colleagues have penciled in a year-end target of 1.4% for the 10y, or marginally higher than current levels. Markets have to price in the interplay between softer data and the Fed's response to softer data, which raises the likelihood that future data will improve. Moreover, Fed stimulus is not the only support coming down the line – infrastructure remains a very important market catalyst. Thus, our expected USD reaction here and the long safe havens trade should be viewed as tactical and temporary, not sustained and structural. So what taper scenario gets the USD weaker? This is a tough needle to thread. In essence, we would need to see a taper scenario that generates lower real yields but wider breakevens – Regime 1 of our framework. To achieve this, we'd have to see two things play out at the same time. To generate wider breakevens, the Fed would have to taper in a more dovish manner than market expectations. But, it would have to do so in a state of the world where the delay in tapering relative to the market isn't driven by softer data, which would instead push breakevens tighter. That is, the Fed would need to be proactively dovish, not reactively dovish (as is the case in our existing delay-taper scenario). How likely is this? Based on the trajectory of US data, COVID-19 vaccinations and hospitalizations, and recent Fedspeak, probably not too likely. Inflation data have been firmer than the Fed had been expecting and labor market tightening is continuing at a rapid pace. Instead, the more likely candidate for a weaker USD is from outside the US. Global growth expectations are re-rating lower and may, at some point, go too low, suggesting an upside surprise in global growth. An increasing number of global central banks are turning more hawkish (e.g., RBA, RBNZ) and, importantly, their reaction functions appear to be getting increasingly insensitive to COVID-19 lockdowns due to expected higher vaccination rates, suggesting that the risk of a dovish turn amid higher case counts is lower. An earlier-than-expected Fed taper, but one coupled with very robust global growth and foreign central banks outpacing Fed hawkishness, likely sees USD weakness, not strength. 35 Trade idea: Maintain short EUR/USD at 1.1801 with a target of 1.1700 and stop of 1.2150 CHF | Selling CHF/NOK MORGAN STANLEY & CO. INTERNATIONAL PLC Gek Teng Khoo Gek.Teng.Khoo@morganstanley.com +44 20 7425-3842 CHF has caught investors’ attention as it was the strongest G10 currency in July, even despite EUR/USD trading stable. The Swiss National Bank (SNB) did not intervene in FX markets while EUR/CHF was breaking below key levels, but it may have returned to the markets last week. In our view, the EUR/CHF weakness was driven mainly by the fall in global bond yields, and the SNB could have stayed on the sidelines as equity and FX market volatility remained low. Given that we expect US real yields to rise from here, USD/CHF and EUR/CHF should see gains. The upside for EUR/CHF, however, may be limited by the dovish ECB keeping German yields low. Positioning also favours a weaker CHF, as short-term investors had been buying CHF in recent weeks. We suggest selling CHF/NOK on the back of our expectation for a steeper US 2s10s curve, monetary policy divergence, NOK trading cheap versus oil prices, and cleaner positioning in both CHF and NOK. We also stay long USD/CHF via 1y risk reversal. Exhibit 52: EUR/CHF has rebounded recently as US real yields bottomed Exhibit 53: EUR/CHF has seen a strong relationship with US real yields Source: Bloomberg, Macrobond, Morgan Stanley Research Source: Bloomberg, Macrobond, Morgan Stanley Research 36 Why has EUR/CHF been so weak? EUR/CHF weakened significantly in July from close to 1.10 to ~1.07, reversing the whole rally seen earlier in the year to reach the weakest level since November 2020. The move has surprised some investors as the pair continued to decline despite risk appetite stabilising in the second half of the month. We think the move lower can be attributed to the fall in bond yields globally, as EUR/CHF continued to track German Bund yields (both real and nominal) very closely (Exhibit 54). What does the decoupling of US vs eurozone real yields mean for EUR/CHF? A similar trend can also be seen between EUR/CHF and US real yields, as US and German yields have moved in tandem (Exhibit 52). Given that we expect real yields in the US and eurozone to decouple from here – with the US's rising while the eurozone's remains low – this raises the question of what this means for EUR/CHF. Do US or eurozone real yields matter more for the currency pair? Exhibit 54: The EUR/CHF weakness can be explained by the fall in German yields Exhibit 55: Relationship between EUR/CHF and eurozone real yield not as strong as with US real yields 6m rolling R^2, regression of EUR/CHF with real yields 100 (on levels) 80 82% 60 40 38% 20 Source: Bloomberg, Macrobond, Morgan Stanley Research 0 Jun-17 Jun-18 Jun-19 Jun-20 Jun-21 US 10y real yield Eurozone 10y real yield Source: Bloomberg, Macrobond, Morgan Stanley Research Interestingly, a regression of EUR/CHF versus US real yields shows that the relationship between the two has been strengthening since March, even before eurozone real yields started exerting their effect on US real yields in July. EUR/CHF's relationship with US real yields has now become even stronger than with eurozone real and nominal yields (Exhibit 55). Historical performance since 2016 also suggests that US real yields are more important for the EUR/CHF direction – when US real yields rise, EUR/CHF appreciates regardless of the direction of eurozone real yields (Exhibit 56). 37 Exhibit 56: EUR/CHF gains when US real yields rise, regardless of how eurozone real yields move 0.25 Weekly move in EUR/CHF (%) 0.20 0.15 0.10 0.05 0.00 -0.05 -0.10 Average -0.15 Median USD RY ↑, USD RY ↑, USD RY ↓, USD RY ↓, EUR RY ↑ EUR RY ↓ EUR RY ↑ EUR RY ↓ Source: Bloomberg, Macrobond, Morgan Stanley Research. Note: RY = real yields. Exhibit 57: EUR/CHF rises when the eurozone-US 10y real yield differential falls Source: Bloomberg, Macrobond, Morgan Stanley Research Coupled with the fact that recent correlations also suggest EUR/CHF should appreciate when the eurozone-US 10y real yield differential falls (Exhibit 57), this implies that US real yields moving higher should result in EUR/CHF strength, even if eurozone real yields remain stable or move somewhat lower. That said, the correlation between EUR/CHF and eurozone bond yields – both real and nominal – remains high, so a dovish ECB keeping a lid on eurozone yields may limit the upside for EUR/CHF (Exhibit 58). EUR/CHF also continues to track the broad money supply M3 growth differential between the eurozone and Switzerland, so a dovish ECB keeping euro area M3 growth high caps the upside for the FX pair from this angle too (Exhibit 59). Exhibit 58: EUR/CHF is still highly correlated with eurozone Exhibit 59: Dovish ECB keeping eurozone money supply bond yields growth high limits the EUR/CHF upside Source: Bloomberg, Macrobond, Morgan Stanley Research Source: Bloomberg, Macrobond, Morgan Stanley Research 38 Swiss National Bank (SNB) is intervening in FX markets again One factor that may have contributed to the EUR/CHF weakness seen is the lack of SNB FX interventions to ease the CHF appreciation. Throughout the month of July, the SNB surprisingly did not engage in FX interventions even despite EUR/CHF breaking below 1.08, which has in the past been one of the key levels for the central bank. The latest sight deposits data, however, suggests that the SNB may have intervened in FX markets last week (August 2-6), for the first time since mid-May (Exhibit 60). This coincided with EUR/CHF finding a bottom at 1.0720, as US real yields also started rising (Exhibit 52). We expect the SNB will continue intervening in FX markets during periods of market volatility to smooth CHF appreciation, with 1.05 in EUR/CHF being the line in the sand for the central bank, in our view. Exhibit 60: SNB returned to intervene in FX markets last week Exhibit 61: EUR/CHF long positions in the options market have been pared back Source: Bloomberg, Macrobond, Morgan Stanley Research Source: Bloomberg, Macrobond, Morgan Stanley Research CHF positioning With the CHF rally seen, the short CHF positioning (against EUR) in the options market is now cleaner as it has been pared back meaningfully over the past month (Exhibit 61). In fact, CHF is now standing out as the largest G10 long position among shorter term leveraged funds in the futures market, and sentiment is also one of the most bullish within the G10. We think this has made the risk/reward of selling CHF to position for higher US real yields more attractive. Selling CHF/NOK We suggest selling CHF/NOK accordingly. CHF should weaken as US real yields rise, and short positioning is now cleaner in the options market as well. In contrast, NOK should benefit from a steepening in the US 2s10s yield curve (Exhibit 62). We also expect Norges Bank to remain hawkish and continue to signal a front-loaded rate hike cycle at its meeting next Thursday (August 19). 39 Exhibit 62: US yield curve steepening should weaken CHF/NOK Source: Bloomberg, Macrobond, Morgan Stanley Research Exhibit 63: Markets are pricing in a more gradual hiking cycle than signalled by Norges Bank 1.8 Norges Bank policy rate (%) 1.6 1.4 1.2 1.07% 1.0 0.96% 0.8 0.6 0.4 0.2 0.0 Jan-18 Jan-19 Jan-20 Jan-21 Jan-22 Actual Norges Bank projection Market pricing Source: MS STIRT, Morgan Stanley Research After the recent repricing in global rates, the rates market is now pricing in a more gradual rate hiking cycle than signalled by Norges Bank. Markets are pricing in a high chance (~87% probability) of two rate hikes this year, but the 2022 rate hikes are priced for June and December, versus March and June signalled by the central bank, which we think it will deliver. There is thus room for markets to bring forward their pricing of hikes, in our view. NOK is also trading cheap versus oil prices, and long positioning in NOK/SEK is cleaner now, we think, after the 6% weakness since April. The risk to this trade is a sell-off in risk appetite. Trade idea: Enter short CHF/NOK at 9.596 with a target of 9.100 and stop of 9.800 Trade idea: Maintain long USD/CHF 1y risk reversal, buy 0.9450 call, sell 0.8850 put, to receive 0.21% (priced on 18-Jun-21) MORGAN STANLEY & CO. LLC NZD | RBNZ preview: A dovish liftoff David S. Adams, CFA David.S.Adams@morganstanley.com Andrew Watrous Andrew.Watrous@morganstanley.com +1 212 761-1481 +1 212 761-5287 We, along with broad-based market consensus, expect the RBNZ to hike rates at its upcoming August meeting, making it the first G10 central bank to lift off since COVID-19 began (Exhibit 64). Quite remarkable considering negative rates were treated as a 'done deal' a mere 12 months ago. 40 However, we are skeptical that the RBNZ will hike 50bp at this meeting - +25bp, raising the cash rate to 50bp, is plenty, in our view. Moreover, we are more skeptical that the RBNZ will show in its updated OCR forecasts either an accelerated pace of hikes beyond the 2-3x per year implied in May or an implied terminal rate in 2024 above its current neutral rate estimate of 2%. We explored this topic in greater detail last week, see more here. As a result, we think the market will view this as a 'dovish hike' - suggesting we should remain short NZD (in this case via long AUD/NZD) and remain received the November RBNZ meeting. Trade idea: Maintain long AUD/NZD at 1.0472 with a target of 1.08 and stop of 1.035 Trade idea: Maintain receiving the November RBNZ meeting at 89bp Trade idea: Maintain 5s30s ACGB steepener at 145bp In addition to fully pricing in a 25bp rate hike at the August meeting, markets are penciling in a bit of risk of a 50bp hike as well. We think this makes sense given the absence of clear guidance from the RBNZ, but we doubt they will actually go 50bp. Exhibit 64: Markets have fully priced in liftoff and are even pricing in some risk of a 50bp liftoff Exhibit 65: New Zealand's economy has seen nearly 100bp of implied policy tightening Source: Macrobond, Morgan Stanley Research Source: Macrobond, Morgan Stanley Research What's to be gained? Risk/reward for a "double liftoff" is poor from a central banker's perspective, in our view. Economic data have been very robust, this is true. But monetary policy operates with long and variable time lags - often lasting as much as 18 months. The economic impact of hiking 50bp in August versus 25bp in August then 25bp seven weeks later in early October is minimal. Conversely, the risk of overtightening financial conditions is real. Hiking 50bp at liftoff is a strong signal to the market that the RBNZ views itself as very "behind the curve", implying that a fast pace of tightening is required. 41 Markets in this scenario are likely to price in: 1) more term premium for 50bp incremental hikes going forward (if they did it before, they can do it again); 2) a faster pace of hikes as the 50bp liftoff shows they are in quite a hurry; and 3) a terminal rate above neutral and likely curve inversion, as the RBNZ in this scenario is likely eager to cool off a perceived-to-be-overheating economy. That's quite a lot of policy tightening to come - perhaps more than is warranted or wanted. This is particularly true given that the risks are far from negligible that 1) data begin to roll over, and 2) COVID-19 returns to New Zealand's shores. A tightening in financial conditions as lockdowns rise or as inflation pressures abate is very real. The belowconsensus US CPI print this week is perhaps an early sign that the Fed's rhetoric on transitory inflation pressures is being validated and may apply to New Zealand as well. Exhibit 66: NZ's shadow short rate has risen the most among its DM peers amid RBNZ hawkishness Source: Macrobond, Morgan Stanley Research Exhibit 67: The RBNZ's LSAPs have slowed markedly in 2021 from 2020 NZ$bn 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Mar-20 RBNZ Purchases of NZGBs NZ$bn 70 60 50 40 30 20 10 0 Jun-20 Sep-20 Dec-20 Mar-21 Jun-21 Weekly Cumulative (rhs) Source: RBNZ, Morgan Stanley Research It's also important to remember that the RBNZ has been tightening policy a lot already. Exhibit 65and Exhibit 66show our estimate of New Zealand's shadow short rate both over time and relative to its peers since mid-June. The bear flattening in the NZ yield curve - driven in part by lower global long-end yields, but more meaningfully by rising expectations for rate hikes - has generated a tightening of nearly 100bp of policy tightening (or the equivalent of nearly four rate hikes) since early June. This is also related to the fact that the RBNZ has slowed its LSAP program markedly in recent months (Exhibit 67). Of the ~NZ$53bn in bonds purchased by the RBNZ over the course of its program, only 20% of the purchases took place this year. Given how much tightening is already passing through, and given how much extra (and unwarranted) tightening would take place if they hike 50bp, we are skeptical they will do it. Risk/reward is just simply not compelling. 42 MORGAN STANLEY & CO. LLC If, on the off chance, they do pencil in a faster pace of tightening than the May MPS and/or pencil in rate hikes above neutral, we think the risks would rapidly rise that the NZ yield curve would flatten and eventually invert. As we've discussed previously, as the timing of liftoff has been brought forward, the market-implied terminal rate has been falling. That's not a good signal. Thus, if we do see a hawkish RBNZ meeting with these faster and higher projections taking place, we might consider entering bear flattener trades in NZ rates relative to other markets like the US or Australian curves (we continue to maintain our 5s30s Australian steepener recommendation). A dovish hike as we expect might steepen the curve enough to offer a more attractive entry point. CAD | Inching back into CAD longs Andrew Watrous Andrew.Watrous@morganstanley.com David S. Adams, CFA David.S.Adams@morganstanley.com +1 212 761-5287 +1 212 761-1481 There have been several developments to the Canadian outlook since our last update. Investors have reduced net long CAD positioning, and a key trader survey suggests that bearish CAD sentiment has reached stretched levels. BoC expectations have also adjusted closer to levels we consider fair. Finally, the recent rise in USD/CAD has lifted it to levels inconsistent with current oil prices and short-term interest rate differentials. For all of the above reasons, we think the time is right to enter long CAD positions. However, given our expectation for continued USD gains as the Fed tapers its asset purchases later this year, we are recommending long CAD against currencies that typically weaken when US real rates rise. Given how CAD has previously traded during episodes when US real rates were rising, we expect CAD gains to be most pronounced against low-yielding currencies like JPY and SEK. We therefore recommend investors enter long CAD/JPY positions targeting 92.00. If CAD/JPY were to fall to 85.50, we suggest exiting the trade and reassessing the CAD outlook. A risk to the trade is that oil prices fall steeply, weighing on CAD. Trade idea: Enter long CAD/JPY at 87.66 with a target of 92.00 and stop of 85.50 Trade idea: Maintain long BAZ2 at 98.91 43 Positioning: CFTC data indicate that as recently as a few weeks ago, net CAD positioning had reached notably long levels. In June 2021, net long CAD positions reached the most extreme levels seen since the onset of COVID-19 (Exhibit 68). Stretched net long CAD positioning was a key reason why we recommended long USD/CAD positions in May. Over the past few weeks, investors have reduced net long CAD positions; the most recent CFTC data indicates that net CAD positioning is very close to the historical average. In addition, trader surveys suggest that CAD sentiment has turned decidedly bearish over the past two months (Exhibit 69) as USD/CAD has rallied from just above 1.20 to around 1.25. Exhibit 68: CFTC positioning is cleaner than it was in May/June Exhibit 69: Trader sentiment on CAD has turned bearish since the July rise in USD/CAD Source: CFTC, Bloomberg, Morgan Stanley Research Source: trade-futures.org, Bloomberg, Morgan Stanley Research The speed of the recent CAD positioning adjustment (reduction of net long positioning and rising bearish CAD sentiment) suggests that further CAD losses will be limited. Direction of Real Yields: As we discuss here and here, we expect US real yields to begin decoupling from still-falling European real yields. The USD has historically gained when US real yields rise, a key driver of our bullish USD outlook. Depending on whether TIPS breakeven yields widen or narrow, we classify market environments where US real yields rise as either "regime 2" (when TIPS breakeven yields widen) or "regime 3" (when TIPS breakeven yields tighten). As we discuss in United States | July CPI: strong under the hood, we have a neutral view of the future direction of TIPS breakeven yields. Breakevens should tread water or may tighten slightly, stuck between robust CPI prints and a vigilant Fed. We therefore recommend trades that perform well on average when US real yields rise, without taking a strong view on TIPS breakeven yields (Exhibit 71). In other words, we recommend trades that perform well if we expect an equal probability of regime 2 or regime 3. 44 Exhibit 70: Breakeven yields are around levels consistent with the Fed achieving 2% PCE over the medium term Exhibit 71: CAD losses are relatively limited when US real rates rise Average CCY/USD monthly change (bp) 50 Regime 2 ↑ = CCY Strength 0 -50 Average -100 Regime 3 -150 ↓ = CCY Weakness -200 Regime 3 (US Real Yields ↑, Breakevens ↓) Average Regime 2 (US Real Yields ↑, Breakevens ↑) -250 Source: trade-futures.org, Bloomberg, Morgan Stanley Research Source: Bloomberg, Morgan Stanley Research On average, CAD typically outperforms most G10 or EM currencies during episodes when US real yields rise (i.e. on average during regime 2 or regime 3). The intuition for a resilient CAD is that expected Canadian investment returns typically rise when US real return expectations are rising due to the close links between the Canadian and US economies. CAD gains are particularly notable against JPY. JPY is one of the few currencies that fare better in regime 3 than regime 2, but its average performance during regimes 2 and 3 (1.07%/month) is the worse across G10 and major EM currencies. Oil: Our oil strategy colleagues expect Brent oil prices to be in the mid-to-high $70s for the remainder of 2021, and to still be supported well above $70/bbl throughout 2022. That expectation is founded on our forecasts for strong global growth, a strong downward trend in global oil inventories, and an expectation that OPEC+ will continue to act to manage the oil market. Exhibit 72: CAD trades cheap to oil prices... Exhibit 73: … and to 2y yield differentials Source: Macrobond, Morgan Stanley Research Source: Macrobond, Morgan Stanley Research 45 Even if oil prices were to remain at current levels, CAD is currently trading below levels consistent with the recent rise in oil prices. CAD tracked oil prices higher until May 2021, but gains have recently stalled. We therefore expect any potential decline in oil prices to have limited negative impact on CAD. BoC/Fed Expectations: CAD has historically traded closely with 2y yield differentials to the US. However (similar to its relationship with oil prices) CAD is currently trading below levels consistent with front end yield differentials. We continue to think that the Bank of Canada delivers two 25bp hikes late next year, which should support long BAZ2 positions. The Z2 has risen since we initially recommended long positions, but we expect it to continue to gain until the Z2 contract is roughly 50bps above Z1 (Exhibit 74). Reduced expectations for near-term BoC hiking (and resulting lower front-end Canadian yields) would weigh on CAD, all else equal. However, long BAZ2 positions effectively hedge the risk that the Bank of Canada turns significantly more dovish. In addition, we observe that CAD's relationship with front-end Canadian yields (and front-end yield differentials) has declined in recent months. Exhibit 75 shows the correlation between CAD and various measures of market yields, yield differentials, and measures of market expectations for BoC policy. Our M1KE, P1KE, and P0KE measures use OIS pricing to gauge how many months in the future the market expects the BoC to deliver an initial 25bp hike (M1KE, MSM1KECA Index), how many 25bp hikes the BoC will deliver in the 12 months after an initial hike (P1KE, MSP1KECA Index), and how many 25bp hikes the BoC will deliver in the 12 months following the current date (P0KE, MSP0KECA Index). Exhibit 74: We expect Z2 pricing to adjust to levels consistent with 2 hikes Exhibit 75: P1KE and M1KE have historically been important to CAD, but the correlation has declined recently Source: Bloomberg, Macrobond, Morgan Stanley Research Source: Bloomberg, Macrobond, Morgan Stanley Research CAD has shown a strong and consistent relationship with both M1KE and P1KE. CAD gained over the past 18 months as the market has priced earlier liftoff from the BoC (i.e. lower M1KE). And CAD also gained over the past 18 months as the market has priced a faster pace of post-liftoff hikes (i.e. higher P1KE). 46 Both of these measures (M1KE and P1KE) have shown a stronger and more consistent relationship with CAD than other measures of yields and yield differentials. CAD has been more consistently correlated with P1KE and M1KE than a variety of other measures - including BAZ2. In addition, CAD's correlation to all yield and yield differential measures has declined in recent months. We take two lessons from this. First, our expectation that BAZ2 contracts rise (implying fewer BoC hikes by end-22) may have relatively limited implications for CAD. Second, our Canada M1KE and Canada P1KE measures are useful tools (relative to other rates measures) for gauging the direction of CAD. JPY | Potential ramifications of public pension portfolio rebalancing for JPY cross-rates MORGAN STANLEY MUFG SECURITIES CO., LTD. Koichi Sugisaki Koichi.Sugisaki@morganstanleymufg.com Shoki Omori Shoki.Omori@morganstanleymufg.com +81 3 6836-8428 +81 3 6836-5466 Strong recovery in cyclical stocks, but heavy price action in CCY/JPY The greenback has strengthened virtually across the board in line with a rise in US real yields after the July Employment Situation report pointed to a further improvement in the US labor market and thus caused many market participants to price in a commencement of Fed tightening. The employment numbers also suggest that reopening of the US economy is progressing relatively smoothly despite the spread of the Delta variant, which likely helps to explain recent rebounds in cyclical and so-called "reopening" stocks. Improved risk sentiment will likely be viewed as an incentive to short JPY – as a "funding currency" – against "asset currencies". Exhibit 76: While cyclical stocks (MSXXHBC Index) rebounded after the June NFP print, CCY/JPY performance has lagged Exhibit 77: The same situation can be seen versus reopening beneficiaries (MSXXOPN2 Index) Source: Bloomberg, Morgan Stanley Research Source: Bloomberg, Morgan Stanley Research 47 Meanwhile, cross-yen rates have yet to match the performance of cyclical and reopening stocks (see Exhibit 76 and Exhibit 77). In Higher US yield, weaker JPY, we suggested that this sluggishness might be a reflection of overseas investors having already shorted the yen quite heavily. Pension funds rebalancing might weigh on CCY/JPY Another possibility is that Japan's public pension system has been rebalancing its portfolio out of foreign equities into domestic stocks. MoF International Transactions in Securities data for July show trust accounts having sold off foreign equities to the tune of over ¥1.1 trillion. Net purchases of foreign bonds were quite limited, suggesting that there is unlikely to have been a big shift out of foreign equities into foreign bonds (see Exhibit 78). As of end-June, public pensions were slightly overweight foreign equities and domestic bonds by comparison with their target range midpoints ("model portfolio") and slightly underweight domestic equities and foreign bonds (see Exhibit 79). Exhibit 78: While trust accounts continue to sell foreign equities, they have not purchased foreign bonds over the past couple of months Source: Japan Mof, Morgan Stanley Research Exhibit 79: GPIF is still likely overweight foreign stocks, and underweight domestic stocks JPY tn 200 180 49.1 160 (25.4%) 140 120 47.8 (24.7%) 100 80 47.3 60 (24.5%) 40 49.1 20 (25.4%) 0 Jun-21 Domestic Bonds 49.7 (25.7%) 48.5 (24.9%) 47.0 (24.2%) 49.3 (25.2%) Aug-21 Domestic Equities Foreign Bonds Foreign Equities Source: GPIF website, Morgan Stanley Research estimates; Note: August numbers are estimated value as of August 13. Japanese equities have underperformed foreign equities further since July, reflecting the continued sluggishness of value and cyclical stocks (which account for such a substantial share of the Japanese market) (see Exhibit 80). Meanwhile, the performance of foreign bonds in JPY terms has been little impacted, with the impact of declines in overseas interest rates basically offset by a strengthening of the yen (see Exhibit 81). It thus seems possible that funds will have been shifted out of (outperforming) foreign equities into (underperforming) domestic equities for portfolio rebalancing purposes. Such rebalancing is likely to have been a source of upward pressure on the yen. We estimate that the public pension system is currently still a little overweight foreign equities and underweight domestic equities (see Exhibit 79), suggesting that the aforementioned rebalancing flows could continue for at least the time being. 48 Exhibit 80: Japan equities have underperformed RoW Jan-2020 = 100 140 130 120 110 100 90 80 70 60 Jan-20 Jul-20 Topix Jan-21 Jul-21 MSCI ACWI JPY Index Source: Bloomberg, MSCI, Morgan Stanley Research Exhibit 81: JPY-based foreign bonds index performance has traded almost flat during this July 530 520 510 500 490 480 470 460 450 Jan-20 Jul-20 Jan-21 Jul-21 FTSE Non-JPY World Government Bond Index (JPY) Source: Bloomberg, FTSE, Morgan Stanley Research That said, once such rebalancing demand is satisfied, we still expect yen cross-rates to rally along with a rise in cyclical stocks as the concerns about the economic slowdown on the back of the Delta variant outbreak are alleviated. We continue to favor USD/JPY longs from a risk/reward perspective. Our US rates strategists expect real yields to head higher as markets price in Fed policy tightening. This would correspond to Regime 2 (rising real yields and rising breakevens) or Regime 3 (rising real yields and falling breakevens) of our USD framework, either of which is ordinarily conducive to a rally in USD/JPY (see Exhibit 82). Exhibit 82: USD/JPY tends to rally in both Regime 2 and Regime 3 Average monthly change, USD v CCY under real yield 250 and breakevens outcomes (bp) 200 Regime 3 150 100 50 0 -50 Regime 2 -100 ↓ = USD Weakness Regime 2 (US Real Yields ↑ , Breakevens ↑ ) Regime 3 (US Real Yields ↑ , Breakevens ↓ ) Source: Morgan Stanley Research Exhibit 83: US breakevens have been a proxy for cyclical stock performance (MSXXHBC Index) Source: Bloomberg, Morgan Stanley Research 49 A fall in breakevens would perhaps be most likely to occur in line with a deterioration in risk sentiment (see Exhibit 83), and cross-yen performance might very well worsen under a Regime 3 scenario of risk appetite waning in anticipation of Fed tightening. But USD/JPY could be expected to hold up comparatively well, with the greenback also having a "funding currency" aspect and as such unlikely to underperform the yen all that dramatically if sentiment should end up shifting back into "risk off" mode (which should be supportive for both USD and JPY). Trade idea: Maintain long USD/JPY at 109.66 with a target of 112.50 and a stop of 108.40 Trade idea: Maintain short 3m USD/JPY call at 112.50 to receive 0.40% (priced 18-Jun-21) 50 G10 | Currency Summary USD Our view: Bullish Risk skew: Bullish Watch: Retail Sales, IP, Housing Housing Starts, FOMC Minutes, Jobless Claims DXY Support: 92.25, 91.75, 91.25, 90.50/75, 89.75, Resistance: 93.25/50, 94.25, 94.75, 95.75, 97.75 We remain bullish on USD and we think gains will be most pronounced versus low yielders. We thus continue to recommend short EUR/USD, long USD/JPY, and long USD/CHF via options. US real yields are likely to continue marching higher as US data remain robust (softer consumer confidence notwithstanding) and Fed tapering is likely to amplify these USD tailwinds. Indeed, next week's FOMC minutes may offer us a glimpse into the conditions under which the Committee might consider an accelerated taper which would in turn open the door to hikes in 2H22. Labor market data remain the primary driver, with the gradual deceleration in CPI less likely to derail the Fed's normalization, which should stand in increasing contrast with more dovish central banks abroad like the ECB and PBOC. EUR Our view: Bearish Risk skew: Bearish Watch: GDP, Inflation, Current Account EUR/USD Support: 1.1700, 1.1625, 1.1500, 1.1425, Resistance: 1.1900, 1.2000, 1.2100, 1.2200, 1.2250/75 We remain short EUR/USD, with an initial target of 1.17. We expect US real yields to rise and decouple from the eurozone’s, which should continue to be weighed down by a dovish ECB: Our economists expect the central to maintain its current “significantly higher pace” of PEPP purchases through December 2021, while a decision on the future of PEPP is now only expected at the October or December meeting. The Fed on the other hand continues to edge closer towards giving advanced notice on tapering, which we expect will happen at the September FOMC meeting. Near-term market positioning has also turned from being short EUR/USD to more neutral, so risk/reward for EUR/USD downside has improved. JPY Our view: Neutral Risk skew: Bearish Watch: GDP, Weekly MoF Data USD/JPY Support: 109.00, 108.75, 107.75, 107.00, 106.25, Resistance: 110.75/111.00, 111.75, 112.25/50, 113.75 We remain long USD/JPY as we see higher US real yields and benign risk conditions. The continued recovery in the US labor market seemingly addressed the concern about a Delta variant outbreak and the subsequent slower reopening to some extent, and led to the strong bounceback of cyclical stock performance. Such strong cyclical stock performance will likely encourage the weakness of funding currencies versus asset currencies. We continue to prefer USD as long leg, Our US rates strategists expect real yields to start heading higher as markets price in the Fed policy tightening path. This would correspond to Regime 2 (rising real yields and rising breakevens) or Regime 3 (rising real yields and falling breakevens) of our USD framework, either of which is ordinarily conducive to a rally in USD/JPY. GBP Our view: Neutral Risk skew: Bullish Watch: Unemployment, CPI, Retail Sales GBP/USD Support: 1.3800, 1.3675/1.3700, 1.3575, 1.3450, 1.3200, Resistance: 1.4000, 1.4100, 1.4250, 1.4350/75, 1.4550 We continue to see GBP outperforming on the crosses, such as against SEK and EUR. GBP/USD continues to trade cheap versus the S&P 500 and monetary policy rate differentials. Part of the reason for the GBP discount is due to the UK yield curve flattening in line with the global trend, weighing down on GBP. Our rates strategists think the gilt curve should steepen from here, thus this should provide some support for GBP. The Bank of England also remains one of the more hawkish G10 central banks. EUR/GBP has broken below the 0.85 level, with 0.84 the next level eyed. GBP/USD may stay relatively range-bound as we expect USD to remain strong too. Long GBP positioning has increased recently but is not stretched yet. CHF Our view: Bearish Risk skew: Bearish Watch: SNB Sight Deposits, Industrial Production EUR/CHF Support: 1.0725, 1.0675, 1.0625, 1.0500, Resistance: 1.0850, 1.0975, 1.1000/25, 1.1100 We continue to like being short CHF and are short CHF/NOK and long USD/CHF via risk reversals. Incoming data suggesting that the SNB may have restarted its FX interventions to prevent CHF from strengthening further have weighed on CHF over the past week, and we see further weakness ahead. Our rates strategists expect US real yields to decouple from their eurozone counterparts and move higher as the Fed edges closer towards an advance notice on tapering at the September FOMC meeting. Higher US real yields should allow both USD/CHF and EUR/CHF to gain, although we think the upside for EUR/CHF may be more limited as the dovish ECB keeps German yields low. Positioning also favors a weaker CHF, as short-term investors had been buying CHF in recent weeks. We don’t think the dovish ECB will result in any changes to SNB policy. 51 CAD Our view: Neutral Risk skew: Bullish Watch: CPI, Retail Sales USD/CAD Support: 1.2425, 1.2325, 1.2275, 1.2200, 1.2125, Resistance: 1.2600, 1.2700, 1.2775, 1.2850, 1.2950 We see the potential for CAD gains on crosses as US real yields rise. Investors have reduced net long CAD positioning, and a key trader survey suggests that bearish CAD sentiment has reached stretched levels. BoC expectations have also adjusted closer to levels we consider fair. Also, the recent rise in USD/CAD has lifted it to levels inconsistent with current oil prices and short-term interest rate differentials. We think CAD can outperform currencies that typically weaken when US real rates rise. We expect CAD gains to be most pronounced against low-yielding currencies like JPY and SEK. We recommend investors enter long CAD/JPY positions targeting 92. AUD Our view: Neutral Risk skew: Bullish Watch: RBA Minutes, Wage Growth, Employment AUD/USD Support: 0.7300/25, 0.7225, 0.7150, 0.7000, 0.6950, Resistance: 0.7425, 0.7500, 0.7600, 0.7650, 0.7775 We continue to look increasingly favorably on AUD though eschew AUD/USD bullishness given our bullish-USD view. A rapid increase in vaccinations, which we expect next month, should enable the lifting of lockdowns and the RBA's reaction function is increasingly insensitive to lockdowns it seems, which means fiscal support will remain the primary means of stimulus. Expansionary fiscal policy and less supportive monetary policy is currencypositive. Meanwhile, AUD short positioning remains and we think this renders it vulnerable to an unexpected pop. We are recommending long AUD/NZD positions targeting 1.08 (1.0350 stop). NZD Our view: Neutral Risk skew: Bearish Watch: RBNZ Decision, Credit Card Spending AUD/NZD Support: 1.0425, 1.0350, 1.0225/50, 1.0150, Resistance: 1.0500/25, 1.0600, 1.0650/75, 1.0800, 1.0875 We remain bullish AUD/NZD and take a relatively less constructive view on NZD into the RBNZ meeting next week. We think we will experience "dovish liftoff" wherein the RBNZ hikes 25bp, avoiding a 50bp rate hike which some in the market are discussing. We are skeptical that the RBNZ's projections will imply a faster pace of hiking or a terminal rate above neutral which would also be dovish versus expectations. A lot of tightening has already taken place in NZ, as measured by our shadow short rates, and we think the RBNZ has little incentive to overtighten particularly given risks that data roll over or that COVID-19 arrives in NZ, generating lockdowns. SEK Our view: Neutral Risk skew: Bearish Watch: Capacity Utilization EUR/SEK Support: 10.16, 10.10, 10.05, 10.03, 9.75/78, 9.45, Resistance: 10.23, 10.25, 10.29/30, 10.35, 10.40 We maintain a bearish skew on SEK. The Riksbank remains one of the most dovish G10 central banks. We expect it to turn less dovish only at its November meeting at the earliest, so in the meantime SEK’s low yield means it can be used as a funding currency against other higher-yielding currencies like GBP and NOK. EUR/SEK should remain broadly within a range, as upside from a weaker EUR/USD is offset by risk appetite staying supported and Swedish growth remaining robust. Global trade has also held up well so far despite the slowdown in Asia economies, which is positive for SEK. However, the housing market in Sweden is showing signs of slowing so this is a downside risk for SEK to monitor. EUR/SEK will need to break above 10.30 to gain more upside room, and we don't expect it to move below 10. NOK Our view: Neutral Risk skew: Bullish Watch: Norges Bank Rates Decision, GDP, Consumer Confidence NOK/SEK Support: 0.9700/25, 0.9650, 0.9500, 0.9400, 0.9300, Resistance: 0.9900, 1.0000/50, 1.0250, 1.0400 We see potential for NOK to strengthen on the crosses and suggest being short CHF/NOK with a target of 9.10. NOK/SEK should also gain, helped by monetary policy divergence and a steeper US yield curve. NOK remains very sensitive to equity market performance and our expectation for risk appetite and oil prices to stay supported should thus be positive for NOK. The current oil price also suggests that EUR/NOK should be trading closer to 9.85-10 based on historical relationships. Focus will be on the upcoming Norges Bank meeting on August 19. The rates market continues to price in a more gradual rate-hiking cycle – particularly for next year – than signalled by Norges Bank. The central bank reaffirming its hawkish stance and front-loaded hiking cycle should thus support NOK. Charts show 3M performance against USD, as normally quoted and DXY for USD. Click on any currency for a reference webpage on Matrix. 52 Inflation-Linked Bonds United States With real yields having driven virtually all upside in yields so far in August, we think more sound data will allow real yields to sell off further, driving nominals higher and causing divergence with real yields in Europe. Real yields should benefit from continued strength in economic data, with the case building for the Fed to give "advanced notice" at the September FOMC. Meanwhile, breakevens should remain range-bound with a tightening bias. Protection should come on the downside from CPI, with our economists continuing to look for core CPI prints north of 4% into the end of the year, and on the upside from a Fed already hawkish about inflation. We break down July CPI, and discuss how trimmed means show strength under the hood despite the core narrowly missing consensus. Trimmed mean inflation touched new highs since 2008 in July, showcasing the impact of deceleration in transient categories such as used cars on the core. Importantly, the rise in trimmed means as well as median CPI also highlights that inflation pressures are broadening out beyond the outliers. The shelter picture was stronger than at first glance, in our view, with strong sequential trends in rent and OER, and stable diffusion not sounding any alarms on the V-shaped recovery in rents. As the labor market continues to improve, both our model-based approach to shelter and real time CoStar data show strong gains ahead. Japan This week we consider the rebasing of Japan's CPI (from 2015 to 2020) along with potential ramifications for JGB linkers. Which index components are likely to be of greatest interest to JGBi market participants? As we had envisaged, the breakeven inflation rate (BEI) for the newest JGBi has recovered to the 20bp level on the back of a rise in nominal JGB yields. We are sticking with a target level of 30bp. 53 MORGAN STANLEY & CO. LLC United States | July CPI: strong under the hood Guneet Dhingra, CFA Guneet.Dhingra@morganstanley.com Henry Steck Henry.Steck@morganstanley.com +1 212 761-1445 +1 212 761-3168 UST yields swayed in a narrow range this week around August refunding and economic data, including CPI, PPI and UMich consumer sentiment, closing Friday mostly unchanged across the curve from last week after a late-week pullback towards 128bp. However, 10y yields mostly held north of the 130bp level over the week, even alongside a notably strong 10y sale and concerns around July CPI. In our view, the story continues to revolve around real yields driving higher nominal yields in the month of August and beyond (Exhibit 84), diverging with European real yields (Exhibit 85). Breaking down the August move in 10y nominals reveals real yields having contributed ~100% of the selloff so far this month, and we look for similar underperformance from real yields to spearhead the vast majority of the move higher in nominals towards year end. Our expectations for further decoupling from European real yields are grounded in US data outperforming, allowing the Fed to provide "advance notice" at the September FOMC. We maintain 10y beta-weighted breakeven tighteners (DV01: 0.7:1) to capture real yield underperformance against nominals alongside our short US 10y call. Exhibit 84: Monthly contributions to 10y nominal yields since February bp 40 34 30 30 20 10 8 0 -7 -10 -4 -20 -12 -30 -25 -40 Feb-21 Mar-21 Apr-21 May-21 Jun-21 Jul-21 Aug-21 BE contrbution RY contrbution 10y nominal Source: Morgan Stanley Research Exhibit 85: 10y TIPS and 10y DBRi yields since May % -0.7 -1.4 -0.8 -1.5 -1.6 -0.9 -1.7 -1.0 -1.8 -1.1 -1.9 -2 -1.2 -2.1 -1.3 May-21 Jun-21 10y TIPS Source: Morgan Stanley Research -2.2 Jul-21 Aug-21 DBRi 10y (rhs) Breakevens were also range-bound this week as the breakeven 5s30s curve continued to flirt with sharp levels of inversion at -33bp (Exhibit 87). Breakevens should tread water or may even tighten slightly, in our view, stuck between robust CPI prints and a vigilant Fed. Importantly, while we judge the July CPI to be strong number under the hood, we don't think breakevens are likely to benefit much, given the elevated levels. It is real yield where we think the impact of strong CPI will be felt. 54 Exhibit 86: Move in TIPS real yields and breakevens in August bp 15 14 10 8 5 11 9 0 -1 -3 -5 6 6 0 5y 10y 30y BE - Change from Jul 30 Nominal Change since Jul 30 Source: Morgan Stanley Research RY - Change from Jul 30 Exhibit 87: Breakeven curves since April bp 0 -5 -10 -15 -20 -25 -30 -35 -40 -45 Apr-21 May-21 5s10s BE Source: Morgan Stanley Research Jun-21 5s30s BE Jul-21 10s30s BE July CPI: Strong under the hood July core CPI posted 0.33% m/m, slightly lower than both MS and consensus expectations (0.4% m/m), with the m/m headline print of 0.5% keeping the y/y headline at 5.4%. Removing expected noise from transient components and outliers amid the ongoing recovery, trimmed mean measures of inflation held firm on the month; the Cleveland Fed's trimmed mean CPI registered a similarly strong m/m reading to June, sending the y/y to a new high since 2008 at 2.99% (Exhibit 88). Exhibit 88: Trimmed mean CPI y/y over the past 20 years % 4.0 3.5 Nov. 2008 3.0 2.5 2.0 1.5 1.0 0.5 Jul-01 Jul-05 Jul-09 Jul-13 Jul-17 Trimmed mean CPI Source: Morgan Stanley Research Jul-21 Exhibit 89: Modeled trimmed mean and median CPI y/y (16%, 24% and 36%) % 3.2 3.0 2.8 2.6 2.4 2.2 2.0 1.8 1.6 1.4 Jul-14 Jul-15 Jul-16 Jul-17 Jul-18 Jul-19 Jul-20 Jul-21 16% trim (Cleveland Fed) 24% trim 36% trim Median Source: Morgan Stanley Research 55 We continue to see trimmed mean measures of inflation as useful tools for tracking CPI trends given they filter out noisy price activity linked to reopening and the rebalancing of supply chains. Utilizing our trimmed mean CPI tool to extract a variety of trimmed means shows these measures picking up across the board, similar to median CPI, and signalling CPI strength under the hood (Exhibit 89). The trajectory of trimmed means points to moderation in pandemic outliers, such as used cars and airfares, as the source of a softer July core print. Importantly, the rise in trimmed means as well as median CPI also highlights that inflation pressures are broadening out beyond the outliers. The sequential trend for shelter was strong in July, a component we view as a key driver of a sustained inflation recovery in coming CPI releases alongside a continued V-shaped recovery in rents. 6m annualized OER and rent posted sequential improvements from June, running at 3.31% and 2.38%, respectively. In addition, our rent diffusion index, tracking the breadth of rent gains across regions, held stable in July compared to June, showing no signs of a broad deceleration (Exhibit 90). We flag that the slowdown in rents and OER was concentrated in the southern region, which confronted higher Covid cases in July. We also note that past downward blips coincident with Covid spikes in 2020 were short-lived for rents in this region. Given the sensitivity of shelter to the Phillips curve, both our model-based approach and real time rent data point to robust gains for rents across coming quarters amid continued improvement in the labor market (Exhibit 91). Class B cities have led the shelter recovery so far, in line with our shelter model that incorporates stronger pandemic home price appreciation in suburban areas compared to urban centers. Exhibit 90: Shelter inflation momentum diffusion (3m MA) % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Dec-03 Dec-06 Dec-09 Dec-12 Dec-15 Dec-18 Shelter Inflation Momentum Diffusion (3m moving average) Source: Morgan Stanley Research Exhibit 91: Class A and Class B shelter inflation alongside model % 5 4 3 2 1 0 -1 Mar-02 Mar-06 Mar-10 A&B shelter y/y Source: Morgan Stanley Research Mar-14 Mar-18 Mar-22 A&B model y/y Perhaps foreshadowed by Manheim and PCE demand data we highlighted recently used cars finally decelerated in July, gaining just 0.2% m/m (SA) against prints of 7.3% m/m and 10.5% m/m in May and June, respectively. Although new autos accelerated, the contribution from autos to July CPI was far less significant than in the prior three months (Exhibit 92). Overall, deterioration in both PCE demand and Manheim data point to further deceleration for used autos, a category firmly in transient column, in our view. 56 Across the basket, components sensitive to reopening were mixed in the July release (Exhibit 93). For example, the pandemic-negative bucket (reopening beneficiaries) decelerated slightly as softer apparel transportation services weighed on strength in energy and hotels. Meanwhile, used cars helped to temper the acceleration of the pandemic-positive category (lockdown beneficiaries), with new cars, food at home, and alcohol showing strength. Exhibit 92: CPI contributions from pandemic-sensitive components % 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0.0 -0.1 -0.2 Feb 21 Mar 21 Apr 21 May 21 Jun 21 Jul 21 Hotels, airfares, recreation, insurance New +Used cars Source: Morgan Stanley Research Exhibit 93: Pandemic positive and pandemic negative buckets of CPI components 8% Pandemic pandemic losers have recovered, winners still strong but 12% 10% 6% 8% 4% 6% 4% 2% 2% 0% 0% -2% -2% -4% -6% -4% -8% Apr-19 Oct-19 Apr-20 Oct-20 Apr-21 Oct-21 Pandemic Positive (lhs) Pandemic Negative (rhs) Source: Morgan Stanley Research With details from this week's CPI and PPI releases in hand, our economists forecast core PCE inflation advancing 0.38% m/m in July, lifting the y/y rate from 3.5%, to 3.6%. They look for a headline print at 0.45% m/m and 4.2% y/y. 57 Exhibit 94: July CPI breakdown Category CPI NSA CPI Food Weight Jul 21 Jun 21 May 21 1 Year 6m 3m 1m 2020 2019 m/m (%) m/m (%) m/m (%) (%) annualize annualize annualize d (%) d (%) d (%) 100.0 0.48 0.93 0.80 5.37 8.92 9.21 5.93 1.36 2.29 100.0 0.47 0.90 0.64 5.28 7.80 8.40 5.84 1.30 2.26 13.8 0.72 0.78 0.44 3.44 5.31 8.05 9.01 3.94 1.83 Energy Core CPI 7.2 1.63 1.47 -0.01 23.61 26.16 13.02 21.43 -7.28 3.43 79.0 0.33 0.88 0.74 4.23 6.80 8.06 4.02 1.61 2.22 CORE SERVICES Shelter Rent OER Out of town lodging Medical care services 58.3 0.27 0.44 0.37 2.83 4.62 4.42 3.29 1.60 2.94 32.6 0.43 0.49 0.29 2.79 4.24 4.97 5.28 1.84 3.24 7.6 0.16 0.23 0.24 1.91 2.38 2.57 1.88 2.29 3.71 23.6 0.29 0.32 0.31 2.43 3.31 3.77 3.53 2.17 3.28 1.0 6.01 6.95 0.40 21.31 54.51 67.90 101.40 -9.66 -0.44 7.1 0.28 -0.04 -0.09 0.82 1.44 0.62 3.45 2.74 5.06 SERVICES (EX-SHELTER, EXHEALTHCARE) Transportation services Recreation Services (rhs) Education Services Other services 18.7 -0.01 0.54 0.68 3.64 6.47 4.89 -0.25 0.75 1.62 5.3 -1.09 1.49 1.53 6.22 13.67 7.92 -12.28 -3.43 0.33 3.7 0.56 0.47 0.15 3.72 6.78 4.85 6.97 1.55 2.60 6.1 0.14 0.12 0.24 1.24 1.58 2.00 1.67 2.34 2.03 1.6 0.98 0.03 -0.06 3.08 4.53 3.87 12.45 2.89 1.83 CORE COMMODITIES Household furnishings Apparel Transportation commodities less fuel Medical care commodities Recreational commodities Education and comm Alcoholic beverages Other goods Source: Morgan Stanley Research 20.7 0.48 2.16 1.82 8.40 13.36 19.35 5.93 1.62 0.03 3.7 0.07 0.14 0.94 3.02 4.77 4.68 0.85 2.95 0.35 2.7 0.04 0.70 1.22 4.20 2.53 8.12 0.50 -4.10 -1.24 7.9 1.01 5.62 3.96 19.70 33.54 51.31 12.78 4.97 -0.13 1.5 0.17 -0.40 -0.02 -2.10 -0.65 -1.01 2.02 -2.48 2.47 2.0 0.53 -0.33 0.39 3.16 4.27 2.40 6.58 -0.25 -0.96 0.5 0.83 -0.18 0.39 -0.15 4.41 4.21 10.43 -2.44 -5.97 1.0 0.30 0.45 0.36 2.44 3.01 4.53 3.68 2.82 0.52 1.5 0.19 0.12 -0.14 2.67 2.38 0.69 2.33 1.84 2.84 Trade idea: Maintain 10y beta-weighted breakeven shorts at 210bp 58 Japan | Energy and mobile phone charges remain a major focus MORGAN STANLEY MUFG SECURITIES CO., LTD. Shoki Omori Shoki.Omori@morganstanleymufg.com +81 3 6836-5466 This week we consider the rebasing of Japan's CPI (from 2015 to 2020) along with potential ramifications for JGB linkers. As we discussed in our previous report, the rebasing and associated changes to index weights have caused Japan-style core CPI (all items, less fresh food) and core-core CPI (all items less fresh food and energy) to fall by more than market participants had anticipated. Below we take a slightly more detailed look at the rebasing impact with a particular focus on those components that are likely to be of greatest interest to JGBi market participants. The changes have had a significant impact on both overall inflation rates and the contributions of individual index components. For example, whereas a 27.91% YoY decline in mobile phone charges had subtracted 0.56%pt from the (2015-base) core CPI inflation rate for June, this negative contribution has almost doubled to –1.08%pt (– 38.49% YoY) as a consequence of the rebasing to 2020. Exhibit 95: 2015 base Japan-style core inflation YoY, %, %pt 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 Jun-18 Dec-18 Jun-19 Dec-19 Jun-20 Dec-20 Jun-21 Food, less FF Recreational services Mobile Phones Others Energy School fees Mobile Phone Charges CPI (All items, less FF) Source: Ministry of Internal Affairs and Communications, Morgan Stanley Research Exhibit 96: 2020 base Japan-style core inflation YoY, %, %pt 1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 Jun-18 Dec-18 Jun-19 Dec-19 Jun-20 Dec-20 Jun-21 Food, less FF Recreational services Mobile Phones Others Energy School fees Mobile Phone Charges CPI (All items, less FF) Source: Ministry of Internal Affairs and Communications, Morgan Stanley Research All else equal we see potential for inflation to slow yet further going forward as baseyear effects also make negative contributions. We say this in part because mobile phone charges will now have a significantly greater weight within the headline, Japan-style core, and core-core indices. Market participants and the general public are more likely to focus on these sorts of indicators than on individual components, for which reason expected inflation rates among households and market participants look set to face downward pressure via the usual "adaptive" (backward-looking) expectation formation mechanism. 59 Some might point to rises in gasoline prices through early July, but a reduction in index weight meant that the contribution of energy-related components to the June core CPI inflation rate ended up falling from 0.36%pt to 0.32%pt. We see ample scope for this to impact household sentiment given that energy-related items have until recently been one of the most obvious sources of inflationary pressure. Exhibit 97: Slight difference in energy inflation 2020=100 113.0 200.0 180.0 108.0 160.0 103.0 140.0 120.0 98.0 100.0 93.0 80.0 60.0 88.0 40.0 Jan-15 May-16 Sep-17 Jan-19 May-20 CPI 2015=100 to 2020 (LHS) CPI 2020=100 (LHS) Dubai Crude Spot (RHS) Source: Bloomberg , Ministry of Internal Affairs and Communications, Morgan Stanley Research Exhibit 98: Household consumption weakening 2015=100 120 115 110 105 100 95 90 85 80 2010 2012 2014 2016 2018 2020 Real Consumption Expenditures (ex. Housing, etc.) Real Consumption Expenditures Source: Ministry of Internal Affairs and Communications, Morgan Stanley Research But we are actually more concerned about the bigger picture for the Japanese economy. The current consensus is that first preliminary GDP estimates for 2Q due on August 16 will show real growth of around +0.5% QoQ annualized, but our own forecast is for +0.2%, some other forecasts point to contractions in GDP, and it also seems unlikely that full allowance has been made for the June Family Income and Expenditure Survey figures showing a 3.2% MoM decline in spending by households with at least two members (suggesting that a downside surprise is an eminent possibility). As we had envisaged, the breakeven inflation rate (BEI) for the newest JGBi has recovered to the 20bp level on the back of a rise in nominal JGB yields. We are sticking with a target level of 30bp. The indexation coefficient has not been affected by the CPI rebasing, and investors in any case appear unconcerned as they contemplate the likelihood of improved carry over the coming months. That said, it does need to be recognized that CPI weights have been reduced not only for energy (a key source of support to this point), but also for recreational services (prices of which look likely to recover as the world returns to some sort of post-COVID "normal"). 60 Short-Duration Strategy United States In the US, we begin by examining where all the reserves in the system have gone, and why reserves have not grown in the last several months. It is increasingly clear that domestic banks are trying to minimize reserve growth, so as not to have lasting impacts on their net interest margins (NIM). The largest domestic banks have been particularly vigilant in limiting continued reserve growth - in fact, most GSIBs saw the level of reserves decline over the last quarter. As a result, reserves are ending up in one of two places: (1) in foreign banks, and (2) back at the Fed via the RRP. Of the RRP's impressive ~$1tn growth YTD to present levels, roughly $200bn of this can be explained by an increase in MMF AUM. So, where did the remaining $800bn come from? This extra $800bn that MMFs have invested in the RRP has come from a roughly $800bn paydown in T-bills YTD. As front-end assets become less available, MMFs have shifted cash away from T-bills and into repo, specifically the RRP facility. We expect this trend to continue as (1) MMF AUM is likely to continue to grow as banks look to pare back reserve and deposit growth, and (2) T-bills are going to continue to get paid down in the coming months as the debt ceiling is in effect. We think the RRP will likely reach a near-term peak of over $1.5tn at the end of September/early October at the height of the debt ceiling (with the potential to exceed this amount on quarter-ends and month-ends). After the debt ceiling is resolved and the Treasury rebuilds the TGA, some of this RRP growth will be undone. But, even by year-end, the RRP is likely to end up at a higher level than where it is presently. Next, we turn back to the debt ceiling. We build off of the analysis done in Stay Short UST, Long USD to consider how a debt ceiling episode akin to 2011 or 2013 would impact repo and unsecured funding. While there is an undeniable increase in noise in repo markets, the impact on ON repo is much more muted compared to that of T-bills. In our view, this is likely because the substitutability between repo and T-bills breaks down as the latter experiences an increased probability of default. Unsecured funding does tend to widen out as the drop-dead date nears. In our view, this is less driven by the cheapening of T-bills and more driven by a broader risk-off sentiment that would accompany a last-minute debt ceiling resolution. 61 MORGAN STANLEY & CO. LLC United States | Follow the money Kelcie Gerson Kelcie.Gerson@morganstanley.com David Harris David.G.Harris@morganstanley.com +1 212 761-3983 +1 212 761-0087 Where have all the reserves gone? We know, based on findings from the Fed's Senior Financial Officer Survey conducted in March 2021, that nearly 70% of domestic banks were intent on reducing the level of reserves on hand. Concerns about net interest margins and return on assets are some of the more important factors influencing this approach to reducing reserves and balance sheets. For GSIBs, there were added concerns around GSIB surcharge scores and enhanced SLR in managing the overall balance sheet. But have they been successful in this endeavor to reduce reserves, especially considering that QE is still ongoing and the TGA has fallen by roughly $1.4tn since the start of the year? Surprisingly, yes. Domestic banks have managed to at least slow, if not reduce the level of reserves on hand over the last quarter. Starting with the GSIBs, most actually saw a reduction in reserves over the last quarter (see Exhibit 99 and Exhibit 100). While on the whole, GSIBs have more reserves on hand than a year ago, and certainly more than two years ago, in the last quarter they have been much more prudent in ensuring reserves don't continue to grow. For example, through the response to the Senior Financial Officer Survey, as well as anecdotally, it is implied that some banks have been encouraging clients to deposit funds into their family of MMFs instead of into the bank itself. It is worth noting that over the last quarter, while JPM's and WFC's reserves fell, the AUM of MMF within their respective family of funds experienced some of the larger AUM increases. Of course, we can't know whether deposits have indeed moved from the bank to the MMF, but we find this coincidence worth highlighting. Exhibit 99: Reserve levels for GSIBs $bn 500 450 400 350 300 250 200 150 100 50 0 Jan-08 JPM Aug-14 WFC BAC Source: Company Filings, Morgan Stanley Research Exhibit 100: Changes over time in reserve levels for GSIBs $bn 150 100 50 0 -50 Mar-21 C GS -100 JPM BAC 1Y Change C WFC GS 1Q Change Source: Company Filings, Morgan Stanley Research 62 As a result of the modest decline in reserves held at the largest domestic banks, reserve concentration amongst domestic banks continues to decline (see Exhibit 101). Further, this decline in the concentration of domestic reserves was driven entirely by the decline in reserves that large banks hold - it's not as if small banks saw massive increases to reserves. In fact, over this last quarter, when the largest banks (those with greater than $250bn in consolidated assets) saw a decline in reserves, both medium-sized banks and small banks saw a levelling off of reserves, not an increase (see Exhibit 102). Exhibit 101: Domestic bank reserve concentration continues to decline 100% 90% 80% 70% 60% 50% 40% 2007Q4 2011Q1 2014Q2 2017Q3 2020Q4 % of Reserves Held by Top 5 Reserve Holders % of Reserves Held by Top 20 Reserve Holders Source: Company Filings, Morgan Stanley Research Exhibit 102: Medium sized banks see the largest 2Q21 increase in reserves, while the largest banks see reserves decline $bn 2,500 2,000 1,500 1,000 500 0 Sep-10 Apr-14 Small Bank Reserves Large Bank Reserves (rhs) Nov-17 Jun-21 Medium Bank Reserves Source: Company Filings, Morgan Stanley Research So, where did all the reserves go? Certainly, we all know reserves can't just disappear. Only the Fed can make that happen. Well, the answer lies in two places: (1) foreign banks, and (2) the RRP. First off, while domestic banks are keen to reduce the level of reserves, foreign banks seem to have taken a much more laissez-faire approach to reserve management, as indicated by the Senior Financial Officer Survey. As a result, while domestic banks pared down their reserve holdings, foreign banks ended up with increased reserves (see Exhibit 103). Over the last quarter, foreign bank holdings of reserves grew by roughly 50% exceeding $1.5tn. But even so, the amount of reserves held by all banks (domestic and foreign) is still much less than we would expect there to be given how much QE continues to happen and given the TGA fell by nearly $300bn in 2Q21 alone and by roughly $1.4tn since the start of the year. Both of these things should have contributed to a substantial increase in reserves, driving reserves to nearly $5tn. So why are they only at ~$4tn? The answer lies within the Fed itself: the RRP facility. Without the RRP facility, we would have expected over $2tn of growth in reserves in the last year (see Exhibit 104). This accounts for all other factors that influence the Fed's balance sheet and reserves, such as QE, changes (higher and lower) to the TGA, a growth in currency in circulation, etc... 63 Exhibit 103: Foreign banks experience substantial increase in reserves $bn 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 Sep-10 Apr-14 Nov-17 Total Reserves of Foreign Banks Total Reserves of Domestic Banks Source: Company Filings, Federal Reserve, Morgan Stanley Research Jun-21 Exhibit 104: Overall reserve growth stalled out despite falling TGA and continued QE $bn 2,500 2,000 1,500 1,000 500 0 -500 Aug-20 Oct-20 Dec-20 Feb-21 Apr-21 Jun-21 Cumulative Expected Change in Reserves w/o RRP Cumulative Change in Reserves Source: Federal Reserve, Bloomberg, Morgan Stanley Research But, instead there was only a little over $1tn of reserve growth to just around $4tn presently. The growth of the RRP, to nearly $1.1tn, fills the gap between the blue and gold line in Exhibit 104, as illustrated by the blue shaded area in Exhibit 105. But how can the RRP grow to nearly $1.1tn if MMF AUM hasn't grown by that much? Where are MMFs getting the cash to invest into the RRP facility? Exhibit 105: Pick-up in RRP explains why reserves have moderated $bn 2,500 2,000 1,500 1,000 500 0 -500 Aug-20 Oct-20 Dec-20 Feb-21 Apr-21 Jun-21 Cumulative Change in RRP Cumulative Change in Reserves Source: Federal Reserve, Bloomberg, Morgan Stanley Research Exhibit 106: Asset re-allocation and modest AUM growth explain source of demand for RRP $bn 1,200 1,000 800 600 400 200 0 -200 Dec-20 Feb-21 Apr-21 Jun-21 Cumulative Change in RRP Cumulative Change in T-bills (inverted) Change in MMF Assets Source: Federal Reserve, Bloomberg, Morgan Stanley Research MMF AUM has grown by about $200bn YTD (see Exhibit 106), and it is safe to assume that a lot of this is coming from banks encouraging clients to put money into MMFs instead of on their own balance sheets, as discussed previously. It is also pretty safe to assume that a lot of this new cash is making its way into the RRP, as there is a limit to other front-end assets that MMFs can invest in. Indeed, the main driving force behind RRP growth is the significant amount of T-bill paydowns that we have seen YTD. 64 As seen in Exhibit 106, there has been over $800bn of T-bill paydowns YTD, which means that the main asset that MMFs (especially gov MMFs) invest in is no longer available. As T-bills have been paid down, RRP usage has increased, nearly 1:1. Indeed, if we look at the relationship between gov MMFs holdings of T-bills and of repo, we can see that they are inversely related (see Exhibit 107), given the two assets are viewed as near substitutes of one another. So, as the availability of T-bills has declined, MMFs have directed cash into repo, and more specifically, into the RRP facility. Indeed, MMFs account for nearly 90% of all RRP usage, with the 10 largest users of RRP accounting for over 40% (see Exhibit 108). As MMF AUM continues to rise, should banks continue to want to reduce deposit growth, and as T-bills continue to get paid down as we expect (see Stay Short UST, Long USD), the number of counterparties using the RRP facility will likely continue to grow, as will the usage by any one individual counterparty. Should some of the largest holders of RRP start to near $70bn of individual RRP usage, it is our view that the Fed will likely raise existing counterparty limits above $80bn. Exhibit 107: Ratio of MMF holdings of repo and MMF holdings of T-bills continues normalization % 70% 60% 50% 40% 30% 20% 10% 0% Nov-18 May-19 Nov-19 May-20 Nov-20 May-21 Repo UST debt Source: Crane Data, Morgan Stanley Research Exhibit 108: Largest MMF holders of RRP as of July 31, 2021 indicate headroom before counterparty limits are breached Top 10 Largest Holders FID01 FDRXX SPAXX FIGXX OGVXX GOIXX DGCXX GVIXX VMFXX Fund Family Fidelity Fidelity Fidelity Fidelity JPMorgan Federated Hermes Dreyfus Wells Fargo Vanguard Other Fed RRP Holdings as of End of July 57.9 55.7 54.2 49.5 45.8 44.0 36.3 32.9 28.4 50.0 Total % of Overall RRP Usage 454.6 43.7% Source: Crane Data, Morgan Stanley Research On the whole, we expect that the RRP will continue to grow. Reserves will likely stay right around $4tn, rising ever so slightly, so the RRP will have to bear the burden of filling the gap, sterilizing forces that would otherwise lead to continued growth in reserves (and deposits). The RRP is likely to peak in size right around the end of September to mid October, when the TGA reaches its lowest point (see Exhibit 109). 65 Exhibit 109: RRP to continue to grow over next two months as debt ceiling episode leads to a decline in the TGA $bn Reserves have remained 4,500 steady just around $4tn.... 4,000 3,500 3,000 2,500 2,000 1,500 ...as decreases in the TGA have led directly to increases in RRP usage 1,000 500 0 Feb-21 Mar-21 Apr-21 May-21 Jun-21 Jul-21 Aug-21 Reserves ($bn) TGA ($bn) If reserves continue to stay just around $4tn.... ...debt ceiling driven declines in the TGA will only further boost RRP usage until a debt ceiling suspension Sep-21 Oct-21 Nov-21 Dec-21 RRP Usage ($bn) Source: Federal Reserve, Bloomberg, Morgan Stanley Research Does a debt ceiling dilemma affect repo and FRA/OIS as much as T-bills? In Stay Short UST, Long USD, we explored how T-bills trade into and during different debt ceiling episodes, particularly those in which a debt ceiling resolution was reached at the last minute, just ahead of the drop-dead date. In this exploration, we came to the conclusion that the shortest-dated T-bills trade the weakest as the drop-dead date approaches, driving a bear flattening of the T-bill curve. But is the same effect seen in repo and in unsecured funding? After all, repo and T-bills are largely seen as substitutes, and substantial moves to T-bills often trickle into unsecured funding markets. In the charts that follow, we conduct a similar event study, where t=0 represents the day in which the debt ceiling was resolved in each of the episodes considered (for the 2011 episode, t = 0 is August 2, 2011; for the 2013 episode, it is October 17, 2013). The line charts themselves illustrate cumulative changes for the underlying asset considered beginning two months ahead of the debt ceiling resolution date. For both repo and unsecured funding, we look at changes vs OIS, so as to not strip out any impacts to the outright rates that could have been driven by changes to Fed pricing. As seen in Exhibit 110, there was certainly an increased amount of noise in repo markets around the debt ceiling resolution, but the impacts are not quite as obvious as in the case of T-bills. While there was some cheapening of repo vs fed funds in the days leading up to the debt ceiling resolution, the magnitude of these moves was much smaller than that of T-bills. This begs the question as to why that is the case, given the two are so inextricably linked. Well, the most obvious explanation is that the substitutability between T-bills and repo breaks down when the probability of a default on T-bills increases. The two are often viewed as effectively riskless investment options, but as one becomes increasingly not risk-free (i.e. T-bills), that substitutability should deteriorate. In that case, repo becomes a much more desired investment for front-end cash, so the impacts are more muted. 66 Exhibit 110: Repo modestly impacted by risk of default in prior debt ceiling episodes, but less than T-bills Cumulative bp move (ON Repo - EFFR) 25 20 15 10 5 0 -5 -10 -15 -42 -28 -14 0 14 28 42 Business Days til Debt Ceiling Resolution Debt Ceiling 2011 Debt Ceiling 2013 Source: Bloomberg, Morgan Stanley Research Exhibit 111: Unsecured funding moves to a small degree in prior debt ceiling episodes in broader risk-off move Cumulative bp move 4 3 2 1 0 -1 -2 -3 -42 -28 -14 0 14 28 42 Business Days til Debt Ceiling Resolution Debt Ceiling 2011 Debt Ceiling 2013 Source: Bloomberg, Morgan Stanley Research Unsecured funding, as measured by FRA/OIS, does in fact widen out (see Exhibit 111). This was particularly true in the 2011 episode, where there was a sovereign debt downgrade from AAA. Our view is that any moves to FRA/OIS are driven by broader risk-off sentiment as opposed to a change in the credit of the underlying CP/CD securities. In fact, the creditworthiness of these unsecured issuers should not be impacted at all by a change in the creditworthiness of the US Treasury. But a risk-off move will naturally lead to widening out of unsecured rates. Should we get into early-to-mid October with no clear indications that there is a debt ceiling resolution on the horizon, this could lead to modest widening of shorter-dated FRA/OIS and spot LIBOR/OIS. Trade idea: Maintain Z1/Z2 FRA/OIS flatteners Trade idea: Maintain long 6m T-bills vs OIS 67 Interest Rate Derivatives United States In the US, we discuss callable issuance, which has been slow this summer despite some significant deals hitting the market this week. We compare the current mix of callable supply to historical issuance, finding that IRRs have continued to shift lower, in line with lower yields. We look ahead to 2022, estimating the amount of outstanding bonds we would expect to be called and re-financed in various rate scenarios. Ultimately, we think that $15-17bn of bonds currently in the market will be refinanced next year, with the majority of that supply hitting the market in the first half of next year. Next, we look into the recent move tighter in swap spreads. Our fair value models have been suggesting 10y and 30y spreads have been wider than fair value for about two months, driven by factors like IG Financial issuance and steeper yield curves. We now think 10y spreads have converged to approximately fair value, but we think 30y spreads have more room to tighten. As a result, we suggest entering 10s30s spread curve flatteners. Lastly, we revisit the roll effect in swap spreads following this week's refunding auctions. We study how benchmark spreads diverge from constant-maturity spreads throughout the year due to differences in maturity, finding this effect is more prevalent in 10y spreads than 30y spreads. MORGAN STANLEY & CO. LLC United States | Setting expectations for spreads and Formosa David Harris David.G.Harris@morganstanley.com Kelcie Gerson Kelcie.Gerson@morganstanley.com +1 212 761-0087 +1 212 761-3983 68 Callable issuance remains low, despite recent action Over the past two months, we have seen callable issuance slow down even below what we would expect based on historical seasonality (Exhibit 118). So far in August, there have been about $530mm of deals announced, compared to approximately $21.6bn through July and behind the pace for a typical August, where we have seen $2.6bn on average over the full month of August since 2014. Year to date, there has been about $22bn of callable issuance, and we would expect all of that issuance to have been swapped in rates markets, impacting spreads and vega (because all of the issuance is from financials, and we assume 100% of financial callable issuance is swapped). Interestingly, despite the low level of overall issuance so far this month, we saw about $400mm in issuance occur in one day this week, which may have led to general underperformance of bottom-right vol earlier this week. Exhibit 112: Cumulative callable issuance is roughly in line with historical trend $bn 70 60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10 11 12 2014 2015 2016 2017 2018 2019 2020 2021 Source: Morgan Stanley Research, Bloomberg Exhibit 113: Monthly callable issuance comparison to recent history Callable issuance, $bn 10 9 8 7 6 5 4 3 2 1 0 12345 2021 Source: Morgan Stanley Research 6 7 8 9 10 11 12 Average 2014-2020 The issuance we have seen so far this year is primarily long-dated, with a majority having greater than 30y in maturity (Exhibit 114). In terms of lock period, we find that about 70% of callable issuance has a standard 5y lock period. There has been relatively more Formosa issuance so far this year, comprising roughly 75% of callable issuance compared to about 70% of issuance last year. Exhibit 114: 2021 YTD callable issuance characteristics 2021 YTD Tenor Category Notional ($) (0, 20y] (20y, 30y] (30y, 40y] >40y (0, 1y] Formosa 16,377,000,000 9% 34% 57% 0% 7% Non-Formosa 5,233,551,000 21% 40% 38% 1% 21% Total Financials 21,610,551,000 12% 35% 52% 0% 10% Formosa 0 NA NA NA NA NA Non-Formosa 0 NA NA NA NA NA Non-Financials 0 NA NA NA NA NA All Callables 21,610,551,000 12% 35% 52% 0% 10% Source: Morgan Stanley Research, Bloomberg Lock Period (1y, 4y] 5y 4% 78% 37% 41% 12% 69% NA NA NA NA NA NA 12% 69% IRR >5y <=2% (2,2.5%) (2.5%, 3.0%) (3.0%, 3.5%) >=3.5% 11% 6% 3% 28% 32% 31% 1% 3% 9% 43% 38% 8% 9% 5% 4% 32% 33% 25% NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA NA 9% 5% 4% 32% 33% 25% 69 Compared to last year, the issuance characteristics are fairly similar in terms of tenor and lock period (Exhibit 115). The most notable difference we see between callable issues this year and last year are the IRR offered by callables this year appears to be lower, with significantly fewer deals offering a IRR above 3.5%. Exhibit 115: 2020 callable issuance characteristics 2020 Tenor Lock Period IRR Category Notional ($) (0, 20y] (20y, (30y, 30y] 40y] >40y (0, 1y] (1y, 4y] 5y >5y <=2% (2,2.5%) (2.5%,3 (3.0%,3.5 .0%) %) >=3.5% Formosa 25,150,250,000 1% 39% 60% 0% 1% 3% 82% 13% 0% 1% 32% 26% 39% Non-Formosa 14,763,100,000 2% 46% 52% 0% 16% 32% 46% 5% 1% 2% 6% 38% 55% Total Financials 39,913,350,000 1% 41% 58% 0% 5% 11% 72% 11% 0% 1% 22% 30% 45% Formosa 9,878,650,000 0% 0% 100% 0% 0% 0% 61% 39% 0% 0% 11% 6% 83% Non-Formosa 0 N/A NA NA NA NA NA NA NA NA NA NA NA NA Non-Financials 9,878,650,000 0% 0% 100% 0% 0% 0% 61% 39% 0% 0% 11% 6% 83% All Callables 49,792,000,000 1% 33% 66% 0% 4% 9% 70% 17% 0% 1% 20% 25% 53% Source: Morgan Stanley Research, Bloomberg As we progress through the second half of the year, we can begin to build expectations for callable issuance next year. We discussed our outlook for callable supply in our midyear outlook, which used assumptions for which bonds would be called based on the eventual path of interest rates. Our team has published rates forecasts through the first half of 2022; therefore, to build out expectations for rate moves further into next year, we use the shape forward swaps curve to guide rate expectations. In Exhibit 116, we consider three outcomes: one in which 30y rates rally to close 2022 at 1.5%, one where they roughly realize the forwards (at 1.78% as of Thursday close), and one where they sell off to 2% by the end of next year. In the rates bull case, we would expect more bonds to be called however a lower portion of those bonds (we assume 50%) will be refinanced as new capital will flow into higher-return assets like ETFs. Conversely, while we expect fewer bonds to be called if 30y swaps sold off from here, we think a potentially more attractive IRR landscape would lead to higher refinancing rate among called bonds. Overall these two effects seem to roughly balance each other out, and we think about $15-17bn of currently outstanding Formosa will be refinanced next year, setting a baseline for vega supply. We do caution that this estimate does not account for any new supply, only refinancing of existing bonds, so these estimates may be on the lower side of what is actually seen next year. Exhibit 116: Callable supply estimates for 2022 Financials Accreted Notional Timeline Eligible to Call 1Q22 22 2Q22 20 3Q22 13 4Q22 6 CY22 62 Amount Called ($bn) Amount Refinanced ($bn) 30y swap 30y swap 30y swap 30y swap 30y swap 30y swap @ 1.5% @ 1.75% @ 2% @ 1.5% @ 1.75% @ 2% 10 7 5 5 6 5 11 8 6 5 7 6 6 4 3 3 3 3 2 2 1 1 1 1 29 21 16 14 17 16 Source: Morgan Stanley Research, Bloomberg 70 What's going on in spreads? Back-end spreads have tightened about 5bp since the beginning of August, following a larger widening move in both 10y and 30y spreads in July (Exhibit 117). We find that throughout the summer, spreads have performed poorly in overnight/Tokyo trading, consistently declining for a cumulative move of about 6bp since the beginning of July (Exhibit 118, MSTZSS3T Index on Bloomberg). Our fair value models have been suggesting 10y and 30y spreads have been wider than fair value for about two months, so given this recent spread underperformance, we took a closer look at our models to inform our view on where spreads could go from here. Exhibit 117: 30y spreads have moved tighter over the month of August Cumulative move, bp 10 8 6 4 2 0 -2 -4 1-Jul 5y spreads 21-Jul 10y spreads Source: Morgan Stanley Research, Bloomberg 10-Aug 30y spreads Exhibit 118: 30y spreads have underperformed in overnight and Tokyo trading Cumulative move, bp 8 6 4 2 0 -2 -4 -6 -8 1-Jul Tokyo 21-Jul New York Morning SourCceu:mMourlgaatnivSteanmleyoRveesearch, Bloomberg 10-Aug London New York Afternoon As shown in Exhibit 119 and Exhibit 120, we see 10y spreads as much closer to fair value while our fair value for 30y spreads has moved even lower. Looking at what may have caused our models to be more bearish on 30y spreads, we find that a steeper 5s30s curve and lower 12m equity returns compared to prior weeks have driven estimates lower, as we find both of those factors to be negatively associated with spreads in our backtesting. 71 Exhibit 119: 10y spreads have moved closer to fair value bp 8 4 0 -4 -8 Apr-21 Jun-21 Aug-21 MS 10y spread fair value Matched maturity 10y spread Source: Morgan Stanley Research, Bloomberg Exhibit 120: Our model thinks 30y spreads can still tighten further bp Swap spread, bp -20 10 8 6 -25 4 2 -30 0 -2 -35 -4 -6 -40 Apr-21 Jun-21 -8 Aug-21 MS 30y spread fair value Matched maturity 30y spread Source: Morgan Stanley Research, Bloomberg We think these relationships are intuitive, as the steeper curve may be pricing in future 30y supply gains relative to other parts of the curve, as shown in Exhibit 122. Over the next few refunding cycles, we think that 30y issuance will increase (net of Fed purchases) while issuance in the belly will move lower. We think this supply effect may continue to bias back-end spreads tighter from here, in line with our model's fair value estimates. Exhibit 121: Projected gross UST issuance by tenor $bn 250 200 150 100 50 0 Aug '21 Nov '21 Feb '22 May '22 Aug '22 Nov '22 2s 3s 5s + 7s 10s 20s 30s Source: Morgan Stanley Research, Bloomberg Exhibit 122: Change in projected gross issuance compared to today $bn 15 10 5 0 -5 -10 -15 -20 -25 -30 -35 Nov '21 Feb '22 May '22 Aug '22 Nov '22 2s 3s 5s + 7s 10s 20s 30s Source: Morgan Stanley Research, Bloomberg 72 We think 30y issuance could outpace 10y issuance in the future (Exhibit 122), and our fair value models show that 30y spreads could continue to tighten from here,. Therefore, we think now is a good time to enter swap spread flatteners. Using our US Volatility Tracker, we find that the 3m rolldown and carry position of a PV01-neutral flattener to be slightly negative, about 0.5bp, which is slightly better than an outright 30y spread tightener, as the 10y spread widener that we would enter as part of the flattener has positive carry. Flagging the swap spread benchmark roll effect As we have discussed in the past, spreads can exhibit misleading moves in periods when a newly-issued 10y or 30y Treasury is auctioned into the market. As this happened this week, we think this price action depends on how a swap spread is calculated, either referencing the spread between an on-the-run bond or a constant-maturity Treasury. In the first case, when a new bond is issued, a benchmark spread (like USSP10 Curncy on Bloomberg) will appear to tighten, assuming an upward-sloping yield curve. This effect exists because the reference UST rolls to a new bond with roughly 3 additional months to maturity, leading to a higher yield on the UST leg (optically tightening benchmark spreads). When we model spreads for our fair value models, we use a constant-maturity Treasury index (like H15T10Y Index on Bloomberg, published by the Fed) to avoid this roll effect. Exhibit 123: 10y benchmark spreads have converged to CMT spreads since the auction bp 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -0.5 -1.0 3-Aug 7-Aug 10y benchmark spread Source: Morgan Stanley Research, Bloomberg 11-Aug 10y CMT spread Exhibit 124: 30y benchmark spreads also converged to CMT spreads following the bond auction bp -24 -26 -28 -30 3-Aug 7-Aug 30y benchmark spread Source: Morgan Stanley Research, Bloomberg 11-Aug 30y CMT spread To gauge the magnitude of this effect, we look at the average spread between benchmark spreads and CMT spreads by month since 2010. Assuming an upwardsloping yield curve, we would expect for this gap to widen as we approach a new issue as the current on-the-run has about 3m shorter maturity than a constant-maturity Treasury. In Exhibit 125, we find that to be the case for 10y notes, as the spread between the on-the-run and constant maturity Treasury is largest in months preceding a new issue auction (which occurs in February, May, August, and November). 73 This effect helps to explain the convergence we see in Exhibit 123. Interestingly, this effect is smaller in magnitude for bonds (Exhibit 125). We think this is largely due to the fact that the 10y part of the curve has generally been much steeper than the 30y part of the curve since 2010, meaning the difference between a 9-year and 9-month vs. 10y note will be larger than a 29-year and 9-month bond vs a newly-issued bond. Exhibit 125: 10y benchmark spreads appear fairly sensitive to the roll effect Avg spread btwn 10y benchmark and CMT spread, bp 1.5 Exhibit 126: Effect is less persistent for 30y spreads given flatter point on curve Avg spread btwn 30y benchmark and CMT spread, bp 0.3 0.2 1.0 0.1 0.5 0.0 0.0 1 2 3 4 5 6 7 8 9 10 11 12 Source: Morgan Stanley Research, Bloomberg -0.1 1 2 3 4 5 6 7 8 9 10 11 12 Source: Morgan Stanley Research, Bloomberg This effect is fairly intuitive and appears to be persistent over time for the 10y benchmark swap spread. It is important to consider the roll to a new benchmark when evaluating spread moves in auction weeks, as we can see misleading tightening moves as a result of the convergence between the benchmark Treasury and the constantmaturity point. Trade idea: Enter 10s30s swap spread flattener, PV01-neutral Trade idea: Maintain 6m10y payer seagull, long ATMF+10bp payer vs short ATMF+50bp payer and ATMF-20bp receiver Trade idea: Maintain 3m10s30s ATMF curve straddle, long 3m10y ATMF straddle Trade idea: Maintain 3m5y payer ladder with downside protection for zero cost Trade idea: Maintain sell 2m10y ATMF straddle and buy 0.6x 5m10y ATMF straddle Trade idea: Maintain buy US 1y30y 1x1 payer spread Trade idea: Maintain buy US 6m5y 1x2 payer spread, struck for zero cost 74 Technical Analysis MORGAN STANLEY & CO. LLC Matthew Hornbach, CMT Matthew.Hornbach@morganstanley.com +1 212 761-1837 Pivot Points Pivot points are charting levels used by day traders to determine market direction, support, and resistance levels. We calculate weekly pivot points using the previous week's open, high, low, and closing levels. Exhibit 127: Government bond yield weekly pivots, support and resistance levels Weekly resistance 3 Weekly resistance 2 Weekly resistance 1 Weekly pivot high Weekly pivot low Weekly Support 1 Weekly Support 2 Weekly Support 3 UST 10y 1.418 1.376 1.349 1.307 1.297 1.265 1.238 1.216 CAN 10y 1.317 1.279 1.256 1.218 1.210 1.180 1.157 1.136 DBR 10y -0.415 -0.433 -0.443 -0.461 -0.466 -0.479 -0.489 -0.497 UKT 10y 0.640 0.618 0.604 0.582 0.576 0.560 0.546 0.537 JGB 20y 0.431 0.426 0.422 0.410 0.407 0.402 0.398 0.393 Source: Morgan Stanley Research ACGB 10y 1.266 1.246 1.233 1.212 1.205 1.192 1.179 1.173 Exhibit 128: Foreign exchange rates weekly pivots, support, and resistance levels Weekly resistance 3 Weekly resistance 2 Weekly resistance 1 Weekly pivot high Weekly pivot low Weekly Support 1 Weekly Support 2 Weekly Support 3 Source: Morgan Stanley Research DXY EURUSD USDJPY GBPUSD AUDUSD 93.45 1.1868 111.23 1.3983 0.7431 93.17 1.1851 110.75 1.3935 0.7416 93.00 1.1831 110.46 1.3905 0.7403 92.73 1.1778 109.98 1.3858 0.7366 92.66 1.1769 109.87 1.3841 0.7358 92.45 1.1752 109.50 1.3810 0.7343 92.28 1.1732 109.21 1.3780 0.7330 92.14 1.1708 108.95 1.3766 0.7313 USDCAD 1.2630 1.2593 1.2569 1.2531 1.2521 1.2494 1.2470 1.2453 Exhibit 129: Foreign exchange rates weekly pivots, support, and resistance levels Weekly resistance 3 Weekly resistance 2 Weekly resistance 1 Weekly pivot high Weekly pivot low Weekly Support 1 Weekly Support 2 Weekly Support 3 Source: Morgan Stanley Research EURJPY 130.10 129.86 129.71 129.47 129.41 129.23 129.08 128.96 EURCHF 1.0887 1.0865 1.0853 1.0809 1.0798 1.0777 1.0765 1.0744 EURNOK 10.6084 10.5383 10.4949 10.4247 10.4080 10.3546 10.3112 10.2745 EURSEK 10.2723 10.2530 10.2448 10.2101 10.2005 10.1812 10.1730 10.1561 NOKSEK 0.9949 0.9917 0.9885 0.9799 0.9783 0.9751 0.9719 0.9680 AUDNZD 1.0535 1.0514 1.0500 1.0479 1.0473 1.0458 1.0444 1.0435 75 MORGAN STANLEY & CO. LLC Cyclical and Secular Trends Matthew Hornbach, CMT Matthew.Hornbach@morganstanley.com +1 212 761-1837 Government Bonds In The Tactical Bull Market Is Back, we discussed a simple methodology based on the Ichimoku Kinko charting technique for classifying market movements as bullish, bearish, or range bound. Then, we define whether the market movement is cyclical or secular in nature. A cyclical move is shorter term in nature, and a secular move is longer term in nature. For cyclical moves, we further divide them into tactical and strategic. We use daily data to inform tactical moves, and weekly data to inform strategic moves. We use monthly data to inform secular movements. Exhibit 130: Summary of cyclical (tactical and strategic) and secular bull, bear, and range bound rates markets UST 2y UST 5y UST 10y UST 30y DBR 2y DBR 5y DBR 10y DBR 30y UKT 2y UKT 5y UKT 10y UKT 30y JGB 10y JGB 20y JGB 30y JGB 40y ACGB 2y ACGB 5y ACGB 10y ACGB 20y NZGB 2y NZGB 5y NZGB 10y CAN 2y CAN 5y CAN 10y CAN 30y Daily Last 0.207 0.773 1.277 1.929 -0.739 -0.730 -0.467 -0.022 0.136 0.295 0.573 0.961 0.031 0.408 0.656 0.741 0.051 0.644 1.217 1.905 1.188 1.380 1.838 0.447 0.842 1.185 1.753 Daily Cloud Lower 0.208 0.829 1.415 2.047 -0.668 -0.592 -0.247 0.251 0.076 0.303 0.679 1.194 0.050 0.429 0.672 0.731 0.058 0.789 1.487 2.121 0.528 1.006 1.759 0.384 0.915 1.356 1.845 Daily Cloud Upper 0.219 0.833 1.476 2.139 -0.668 -0.563 -0.209 0.315 0.097 0.319 0.736 1.258 0.061 0.435 0.674 0.744 0.072 0.792 1.571 2.220 0.594 1.075 1.782 0.426 0.932 1.420 1.960 200d MA 0.159 0.661 1.318 2.026 -0.702 -0.660 -0.374 0.114 0.018 0.205 0.583 1.117 0.060 0.439 0.663 0.716 0.082 0.639 1.384 2.101 0.372 0.822 1.464 0.298 0.739 1.191 1.723 Cyclical Tactical Daily Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bear Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Range bound Bull Market Bull Market Bull Market Bull Market Bear Market Bear Market Bear Market Bear Market Bull Market Bull Market Bull Market Cyclical Strategic Weekly Range bound Range bound Bear Market Bear Market Range bound Range bound Bear Market Bear Market Range bound Range bound Bear Market Bear Market Range bound Range bound Bear Market Bear Market Bull Market Bear Market Range bound Range bound Range bound Range bound Bear Market Range bound Bear Market Bear Market Bear Market Source: Morgan Stanley Research Secular Monthly Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market 76 Foreign Exchange Exhibit 131: Summary of cyclical (tactical and strategic) and secular bull, bear, and range bound FX markets DXY USDJPY USDCAD USDCHF USDNOK USDSEK EURUSD GBPUSD AUDUSD NZDUSD EURJPY NOKSEK AUDNZD USDBRL USDMXN USDARS USDCLP USDCOP USDPEN Daily Last 92.52 109.59 1.2515 0.9156 8.7985 8.6425 1.1797 1.3866 0.7370 0.7042 129.30 0.9822 1.0469 5.2477 19.88 97.11 775.74 3,846.38 4.0780 Daily Cloud Lower 91.19 110.00 1.2299 0.9101 8.4847 8.4408 1.1932 1.3902 0.7553 0.7052 131.40 0.9887 1.0712 5.0871 20.06 94.45 723.96 3,716.27 3.8201 Daily Cloud Upper 91.81 110.51 1.2375 0.9153 8.5908 8.4971 1.2024 1.3991 0.7654 0.7120 131.88 0.9993 1.0725 5.1916 20.17 95.51 737.54 3,741.40 3.8886 200d MA 91.32 107.42 1.2565 0.9076 8.5752 8.4517 1.2012 1.3779 0.7611 0.7113 129.01 0.9860 1.0700 5.3382 20.12 89.63 732.97 3,660.83 3.7397 Cyclical Tactical Daily Bull Market Bear Market Bull Market Bull Market Bull Market Bull Market Bear Market Bear Market Bear Market Bear Market Bear Market Bear Market Bear Market Bull Market Bear Market Bull Market Bull Market Bull Market Bull Market Cyclical Strategic Weekly Range bound Bull Market Bear Market Range bound Bear Market Range bound Range bound Bull Market Range bound Bull Market Bull Market Bull Market Bear Market Range bound Bear Market Bull Market Range bound Bull Market Bull Market USDZAR USDTRY USDILS USDRUB USDPLN USDCZK USDHUF 14.73 8.5237 3.2132 73.23 3.8702 21.5330 298.74 13.98 8.4703 3.2635 73.46 3.7457 21.3197 293.48 14.15 8.6225 3.2683 73.59 3.7802 21.4774 296.19 14.65 7.9819 3.2688 74.50 3.7724 21.5639 298.01 Bull Market Range bound Bear Market Bear Market Bull Market Bull Market Bull Market Bear Market Bull Market Bear Market Range bound Range bound Bear Market Range bound USDCNY USDIDR USDINR USDKRW USDMYR USDPHP USDSGD USDTWD USDTHB 6.4774 14,388.00 74.25 1,168.95 4.2375 50.47 1.3550 27.8590 33.3400 6.4283 14,356.50 73.70 1,125.53 4.1294 48.75 1.3363 27.8550 31.6550 6.4531 14,434.00 74.16 1,131.84 4.1478 48.97 1.3426 27.8860 31.8200 6.5005 14,300.63 73.63 1,120.07 4.1136 48.53 1.3371 28.1904 31.0228 Bull Market Range bound Bull Market Bull Market Bull Market Bull Market Bull Market Range bound Bull Market Bear Market Range bound Bull Market Range bound Bull Market Bull Market Range bound Bear Market Bull Market GOLD SILVER CRUDE OIL 1,780 23.75 68.44 1,807 26.53 68.00 1,834 27.14 72.35 1,814 25.91 58.99 Bear Market Bear Market Range bound Range bound Range bound Bull Market Source: Morgan Stanley Research, Bloomberg Secular Monthly Bear Market Range bound Bear Market Bear Market Bull Market Bear Market Bull Market Bull Market Range bound Bull Market Bull Market Bear Market Bear Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bull Market Bear Market Bull Market Bull Market Bear Market Bull Market Bear Market Bull Market Bull Market Bull Market Bull Market Range bound Bear Market Bear Market Range bound Bull Market Bull Market Bull Market 77 MORGAN STANLEY & CO. LLC G4 Smarter (beta) Trading Strategy Matthew Hornbach, CMT Matthew.Hornbach@morganstanley.com +1 212 761-1837 Enhancements to a G4 10y government bond futures momentum strategy have produced higher Sharpe ratios and stronger returns, relative to total return government bond indices for the G4, US, Germany, Japan, and the UK since 2000. See A "Smarter" (Beta) Way to Trade G4 10y Futures Duration? for more information on these strategies. Trading Strategy 1 – "Trade Longs/Fade Shorts" When the 5-day moving average crosses above the 20-day moving average, buy the futures contract (long duration) and hold for a 25 business day period. When the 5-day moving average crosses below the 20-day moving average, buy the futures contract and hold for a 25 business day period. In short, this strategy buys futures when the Simple Moving Average Crossover (SMAX) generates both a long and a short signal, given the historical outperformance of long signals traded long and underperformance of short signals traded short. Given that the SMAX could generate both a long and a short signal within the predefined holding period, an investor may have a 200% long position since each of the two signals would be traded in separate portfolio sleeves. Trading Strategy 2 – Trade "Longs Only" When the 5-day moving average crosses above the 20-day moving average, buy the futures contract (long duration) and hold for a 25 business day period. When the 5-day moving average crosses below the 20-day moving average, do nothing. In short, an investor ONLY trades long signals initiated by the SMAX given their historical precedent to outperform Exhibit 132: Trading signals for G4 smarter (beta) trading strategy Current Risk, G4 10y Futures G4 Strategy Weight Trade Longs Portfolio Fade Shorts Portfolio JB 10y Future 32.50% 0% 100% Total Risk Trade Longs Only Total Risk Trade Trade Longs Trade Longs Fade Shorts Fade Shorts Longs/Fade Shorts Portfolio Portfolio Exit Portfolio Portfolio Exit (max 200%) Entry Date Date Entry Date Date 0% 100% - - 8/12/2021 9/16/2021 GE 10y Future 29.25% 0% 0% 0% 0% - - - - US 10y Future 30.50% 0% 100% 0% 100% - - 8/11/2021 9/16/2021 UK 10y Future 7.75% 0% 100% 0% 100% - - 8/12/2021 9/17/2021 Source: Morgan Stanley Research 78 Bond Market Indicators Our BMI(10) models are mildly bullish across all markets overall aside from a neutral reading for the UK. The vol-adjusted carry signal is mixed across markets, and is quite positive for Australia at 9.3. Both momentum and equity market signals were quite bullish across the board. Our BMI(2) models stayed mildly bullish on the US, Australia, and New Zealand overall. The vol-adjusted carry signal is notably positive in Australia and New Zealand, while notably negative for Japan and Germany. Momentum signals are mixed with a particularly bearish print for New Zealand. Business cycle indicators are mostly neutral, aside from a bearish tilt for the UK. Our iBMI models are bearish for TIPS & JGBi, and are neutral for HICPxT & UKTi. Equity signal grew more bearish for TIPS, grew less bearish for HICPxT & JGBi, and remained bearish for UKTi . Momentum signal grew more bullish for UKTi & JGBi, turned less bullish for TIPS & HICPxT . Oil signal remained bearish for TIPS, UKTi & JGBi, and turned less bearish for HICPxT. Latest readings Exhibit 133: Morgan Stanley Bond Market Indicators - BMI(10) Vol-Adjusted Carry US 5.0 (3.5) DE -8.4 (-8.8) UK -0.7 (0.8) JP -1.4 (0.0) AU 9.3 (9.1) NZ -1.0 (-1.3) CA 1.1 (-0.9) Momentum 10.0 (10.0) 8.5 (8.2) 9.9 (9.9) 9.7 (9.8) 9.8 (9.9) 6.9 (9.3) 9.9 (9.9) Equity Markets 5.3 (5.2) 6.1 (6.3) 6.9 (7.1) 7.3 (7.4) 4.8 (5.1) 7.2 (6.4) 7.0 (6.9) Business Cycle -2.5 (-7.9) 1.2 (1.2) -9.5 (-9.5) -3.9 (-3.9) 0.9 (0.9) 1.8 (1.8) -0.3 (-2.2) FX -7.6 (-9.9) 0.2 (-1.7) -2.7 (-5.6) 6.5 (7.0) -3.7 (-6.1) 2.3 (4.1) -0.4 (0.1) Average 2.0 (0.2) 1.5 (1.1) 0.8 (0.2) 3.6 (4.1) 4.2 (3.8) 3.4 (4.1) 3.5 (2.8) Overall 2.0 (0.0) 1.5 (0.0) 0.0 (0.0) 3.6 (4.1) 4.2 (3.8) 3.4 (4.1) 3.5 (2.8) Source: Morgan Stanley Research Note: Positive # = long duration; Negative # = short duration, (#) = previous week Thursday close which may differ from the post-nonfarm payroll update, Indicators bounded between -10 and +10, Overall signal set to zero if abs(Signal)<=1.5 79 Exhibit 134: Morgan Stanley Bond Market Indicators - BMI(2) Vol-Adjusted Momentum Equity Markets Business Cycle FX Carry Average Overall US 5.3 (2.9) 6.3 (-6.6) 5.3 (5.2) -2.5 (-7.9) 1.3 (3.0) 3.1 (2.0) 3.1 (2.0) DE -9.2 (-9.6) 8.0 (7.5) 6.1 (6.3) 1.2 (1.2) -1.6 (-1.9) 0.9 (0.7) 0.0 (0.0) UK 7.5 (5.5) 0.4 (-1.4) 6.9 (7.1) -9.5 (-9.5) 2.0 (0.6) 1.5 (0.5) 0.0 (0.0) JP -8.1 (-8.5) 2.3 (1.6) 7.3 (7.4) -3.9 (-3.9) 0.4 (0.9) -0.4 (-0.5) 0.0 (0.0) AU 9.9 (9.8) 6.6 (7.4) 4.8 (5.1) 0.9 (0.9) -7.5 (-8.5) 2.9 (2.9) 2.9 (2.9) NZ 8.6 (7.9) -9.7 (-9.2) 7.2 (6.4) 1.8 (1.8) 6.8 (8.1) 2.9 (3.0) 2.9 (3.0) CA 2.9 (3.2) -4.4 (-4.0) 7.0 (6.9) -0.3 (-2.2) 0.0 (-0.9) 1.3 (-0.9) 0.0 (0.0) Source: Morgan Stanley Research Note: Positive # = long duration; Negative # = short duration, (#) = previous week Thursday close which may differ from the post-nonfarm payroll update, Indicators bounded between -10 and +10, Overall signal set to zero if abs(Signal)<=1.5 Exhibit 135: Morgan Stanley Bond Market Indicators - xBMIs vs. US vs. DE vs. UK vs. JP vs. AU vs. NZ vs. CA Long US 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) 0.0 (-1.9) 0.0 (-1.8) 0.0 (-1.9) 0.0 (0.0) Long DE 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) Long UK 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) 0.0 (-1.9) -1.7 (-1.8) 0.0 (-1.9) 0.0 (0.0) Long JP 0.0 (1.9) 0.0 (0.0) 0.0 (1.9) 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) Long AU 0.0 (1.8) 0.0 (0.0) 1.7 (1.8) 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) Long NZ 0.0 (1,9) 0.0 (0.0) 0.0 (1.9) 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) Long CA 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) 0.0 (0.0) Source: Morgan Stanley Research Note: Positive # = long cross market spreads; Negative # = short cross market spread, (#) = previous week Thursday close which may differ from the post-nonfarm payroll update, Indicators bounded between -15 and +15, Signal is set to zero if abs(Signal)<=2 Exhibit 136: Morgan Stanley Euro Sovereign Bond Market Indicators - eBMI Periphery vs. Core Semi-Core vs. Core Periphery vs. Semi-Core Business Cycle Surprises 8.1 (9.1) 7.1 (7.0) 0.5 (1.1) Momentum 1.8 (2.8) -1.7 (1.0) 1.7 (0.9) Vol. Adj. Carry 9.1 (9.1) 9.5 (9.7) -0.2 (-0.3) Supply -6.8 (9.9) -6.6 (-4.3) -0.1 (7.1) Risky Assets 6.0 (3.5) 9.3 (8.9) -1.6 (-2.7) Overall 3.6 (6.9) 3.5 (4.5) 0.1 (2.4) Source: Morgan Stanley Research Note: Positive # = long spreads; Negative # = short spreads, (#) = previous week Thursday close which may differ from the post-nonfarm payroll update, Indicators bounded between -10 and +10. Exhibit 137: Morgan Stanley Inflation Bond Market Indicators - iBMI Market TIPS UKTi HICPxT JGBi Oil -1.5 (-1.5) -1.6 (-1.6) -1.3 (-1.4) -1.7 (-1.7) Momentum 3.0 (5.5) 6.5 (4.0) 4.4 (7.3) 1.8 (0.9) Equities -3.2 (-2.8) -3.3 (-3.3) -2.7 (-3.1) -3.5 (-3.9) Value -5.2 (-4.5) -4.4 (-4.5) -3.6 (-2.8) -8.1 (-7.9) Average -1.7 (-0.8) -0.7 (-1.4) -0.8 (0.0) -2.9 (-3.2) Overall -1.7 (0.0) 0.0 (-1.3) 0.0 (0.0) -2.8 (-3.1) Source: Morgan Stanley Research Note: Positive # = long inflation breakeven; Negative # = short inflation breakeven, (#) = previous week Thursday close which may differ from the post-nonfarm payroll update, Indicators bounded between -10 and +10, Overall signal set to zero if abs(Signal)<=1.0 How to read the xBMIs The "FX/Rates" row displays the FX/rates relationship signal. The "Combined BMI differential" row displays the difference between the relevant BMI(10) signals after having applied the signal strength check, i.e., abs(signal) >= 1.5. The "Average xBMI" row displays the average of the "FX/Rates" and "Combined BMI differential" rows. And the "Overall" score requires that the sign of the "Average xBMI" signal match the sign of the "Combined BMI differential" signal and be ≥ the absolute value of 2. 80 Swap Spread Indicators Our SSI(2) models imply that 2y spreads are about 3bp wider than fair value. The 0.5sd trading threshold is exceeded. Our model implied fair value can be found on Bloomberg using the ticker MSSIUS2 Index. Our SSI(10) models imply that 10y spreads are about 2bp wider than fair value on the 6m rolling lookback. No trading thresholds are exceeded. Our model implied fair value on Bloomberg: MSSIUS10 Index. Our SSI(30) models suggest that 30y spreads are about 7bp wider than fair value on our 2y lookback window. The 1sd trading threshold is exceeded. Our model implied fair value can be found on Bloomberg using the ticker MSSIUS30 Index. Based on each of the SSI models, the 10s30s spread curve is about 5bp wider than fair value using our 2y lookback window. Detail on the variable selection and model construction of these Swap Spread Indicators can be found in Modeling Swap Spreads. Within the piece, we discuss the various fundamental and flow-related drivers of 2y, 10y, and 30y spreads, and use these variables to construct multivariate regression models. We then develop and test trading strategies that employ these models. Updates to model-implied fair values, as well as backtesting of trading signals, can be found below. The performance data provided is a hypothetical illustration of mathematical principles; it does not predict or project the performance of an investment or investment strategy. Past performance is no guarantee of future results. Latest readings Exhibit 138: Morgan Stanley Swap Spread Indicators - Model Implied Fair Values Spread 2y Swap Spreads 10y Swap Spreads 30y Swap Spreads 2s10s Swap Spread Curve 2s30s Swap Spread Curve 10s30s Swap Spread Curve 6m Rolling Lookback Window 5.1 -1.7 -28.5 -6.8 -33.5 -26.7 2y Rolling Lookback Window 1.2 -3.0 -36.7 -4.2 -36.8 -32.6 5y Rolling Lookback Window 1.3 -4.0 -32.3 -5.3 -33.6 -28.3 Matched-Maturity Swap Spread Level 8.5 0.2 -28.2 -8.3 -36.6 -28.3 Source: Morgan Stanley Research Note: The levels shown in the table are the model-implied fair values for each of the spread sectors using various lookback windows. For curves, we calculate model-implied fair value based on the difference between the model-implied fair value of the two individual spreads that make up the spread curve. 81 Exhibit 139: Morgan Stanley Swap Spread Indicators - Trading Signals Spread Trading signal* Trade with 0.5sd threshold? Trade with 1.0sd threshold? Trade with 2.0sd threshold? 2y Swap Spreads Tighten Y N N 10y Swap Spreads Widen N N N 30y Swap Spreads Tighten Y Y N Source: Morgan Stanley Research Note: The thresholds are derived from the standard deviation of the difference between model-implied fair value and market values for the preferred rolling window for each spread sector. *We use our preferred lookback windows for the trading signals. Our preferred lookback windows, based on regression fit an explanatory power, are 6m for 2y and 10y spreads and 2y for 30y spreads. **For curves, we use 2y rolling regression lookback windows for consistency when constructing the trading signals. Backtesting results Exhibit 140: Backtesting results for each spread sector using preferred lookback window and no trading threshold (last 12 months) bp 20 10 0 -10 -20 -30 -40 Jun-20 Aug-20 Oct-20 Dec-20 Feb-21 Apr-21 Jun-21 2y 10y 30y Source: Morgan Stanley Research *Our preferred lookback windows, based on regression fit an explanatory power, are 6m for 2y and 10y spreads and 2y for 30y spreads Exhibit 141: Backtesting results for each spread sector using preferred lookback window and a trading threshold of 1.0sd (last 12 months) bp 15 10 5 0 -5 -10 -15 -20 Jun-20 Aug-20 Oct-20 Dec-20 Feb-21 Apr-21 Jun-21 2y 10y 30y Source: Morgan Stanley Research *Our preferred lookback windows, based on regression fit an explanatory power, are 6m for 2y and 10y spreads and 2y for 30y spread 82 Government Bond Supply In the US, total coupon issuance (new 20y, 30y TII reopening, new 2y, 5y, 7y) settling at the end of August is estimated $218bn versus $8.3bn coupons and $110.5bn redemptions, resulting in net issuance of $99.2bn. In the euro area, we estimate €19bn of issuance (from GER, FRA, SPA) versus €2.3bn coupons and no redemptions, resulting in net issuance of €16.7bn. In the UK, UKT 0.875% Gilt 2046 will be issued for £2bn against no coupons or redemptions. In Japan, there will be an auction for enhanced liquidity for ¥0.5tr, against ¥5bn coupons and no redemptions. In Canada, 2y CAN Nov 2023 will be issued for C$4bn against no cash flow. In Australia, ACGB 1.5% Jun-31 and ACGB 3.25% Apr-25 will be issued for $800mn and $700mn respectively, against no cash flow. In New Zealand, NZGB 0.5% May-26, NZGB 0.25% May-28 and NZGB 3.5% Apr-33 will be issued for $200mn, $200mn and $100mn respectively, against no cash flow. Exhibit 142: Sovereign supply calendar Monday Tuesday Wednesday Thursday Friday 16-AUG 17-AUG GER: New BKO 15 Sept 2023, €6bn UK: UKT 0.875% 2046, £2bn 18-AUG 19-AUG 20-AUG GER: DBR 0% 15 Aug 2050, FRA: OAT Auction, €6-7bn OAT Mar 2024, AUS: ACGB 3.25% Apr- €1bn OAT 0.5% May 2026, OAT 1% May 2027 25 Tap, $700mn US: New 20y UST, $27bn FRA: Linker Auction, €0.5-1bn OATi 0.1% AUS: ACGB 1.5% Jun-31 Tap, Mar 2028, OATei 0.1% Mar 2029 SPA: $800mn SPGB Auction, €4-5bn* US: 30y TIPS Re-opening, $8bn JPN: Auction for Enhanced Liquidity, ¥500bn CAN: 2y CAN Nov 2023, $4bn NZ: NZGB 0.5% May-26 Tap, $200mn; NZGB 0.25% May-28 Tap, $200mn; NZGB 3.5% Apr-33 Tap, $100mn 23-AUG 24-AUG 25-AUG ***AUS: New ACGBi Nov 2032 via Syndication, $35bn* GER: DBR 0% 15 Nov 2028 Tap, €3bn UK: UKT 0.375% Gilt 2026, £3.5bn* US: New 2y UST, $60bn* JPN: 5y JGB, ¥2600bn* US: New 5y UST, $61bn* CAN: 3y CAN, $4.5bn* 26-AUG ITA: BTPst Auction, €2.5bn* ITA: BTPei Auction, €1.5bn* US: New 7y UST, $62bn* JPN: 20y JGB, ¥1200bn* CAN: 30y CAN, $bn 27-AUG 30-AUG 31-AUG 1-SEP 2-SEP ***FIN: Possible New 5y ITA: BTP Auction, €7-8bn* RFGB Syndication, €3bn* NETH: DSL Tap, €2-2.5bn* JPN: 2y JGB, ¥3000bn* GER: OBL 0% 9 Oct 2026 Tap, FRA: Long Term OAT Auction, €8-9bn* €4bn SPA: SPGB Auction, €5-6bn* UK: New UKT Jan 2029, CAN: 10y CAN, $5bn* £3bn* CAN: 30y Linker, $400mn* Source: Morgan Stanley Research, Treasuries * Morgan Stanley estimate. ** Possible Auction. *** Auction is likely to be conducted in the respective week. 3-SEP 83 QIS Macro Strategy Signals Rates Value - Quantitative Investment Strategies Research: Rule-Based Value Investing Rates Value is a strategy for investing in global 10y government bond futures. The strategy considers a series of market and macroeconomic variables to drive investment decisions, using a LASSO regression to avoid over-fitting. Exhibit 143: Rates Value positioning, last 12 months Country Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Australia 22% 22% 22% 22% 22% 22% 22% 22% 22% 22% 22% 22% Canada -17% -17% 14% 14% -16% 16% 16% 16% -18% 19% 19% -17% France -19% -19% 20% 22% 22% 22% 22% 22% 22% 22% 22% 19% Germany 21% 20% 22% 22% 22% -22% -22% -22% 21% 21% 21% 20% Italy 12% 12% -13% -13% 13% 14% 10% 11% 12% 11% 11% 11% Japan 22% 22% 22% -22% 22% 22% 22% 22% 22% 22% 22% 22% Korea -20% 20% 20% 20% 20% 20% 22% 22% -22% -22% -22% -22% UK 15% 14% 14% 15% 15% 15% 17% -17% 19% 17% 17% 16% US 19% Net Duration 55% Exposure 20% 21% -21% -21% 22% 19% -19% -20% -19% 19% -20% 94% 142% 59% 99% 131% 139% 57% 58% 93% 131% 51% Source: Morgan Stanley Research, Bloomberg Rates Trend - Quantitative Investment Strategies Research: Investing in Central Bank Momentum The Rates Trend strategy invests in the front four contracts of global Short-Term Interest Rate (STIR) futures by trend-following, using different look-back windows to generate long and short signals. The strategy incorporates GARCH, a parsimonious statistical model, to capture the time-varying and clustering aspects of market volatility. Exhibit 144: Rates Trend net contract exposure, last 12 months Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug US 2 2 2 2 2 4 4 4 4 4 4 4 Euro 4 4 4 4 4 4 4 4 -4 -4 -4 -2 UK 4 4 4 0 -2 -2 0 0 -4 -4 -4 -2 Canada 2 4 4 2 2 2 2 2 2 2 2 2 Switzerland 2 4 4 -2 -2 -2 0 0 0 0 0 0 Australia 4 4 4 4 4 -2 -2 4 2 0 0 2 Strategy 3 3 3 2 1 1 1 2 1 0 1 2 Source: Morgan Stanley Research, Bloomberg Note: Numbers represent the net exposure of the strategy among the front 4 contracts for the given country Exhibit 145: GARCH forecasted volatility regimes, last 12 months Sep US Euro Canada UK Switzerland Australia Oct Nov Dec Jan Feb Mar Apr May Jun July Aug Source: .Morgan Stanley Research, Bloomberg. Red indicates a high volatility regime. 84 FX Equity-Driven Momentum - Quantitative Investment Strategies: FX Equity-Driven Momentum FX Equity-Driven Momentum is long/short strategy whose positions in currencies are driven by the relative performance of the corresponding equity markets. The strategy goes long currencies where the local equity market has outperformed the US by Sharpe ratio over the past 3 months, and short currencies which have underperformed the US. Exhibit 146: FX Equity Momentum Positioning, emerging markets, year to date Month BRL CLP CNH COP CZK HUF IDR ILS INR KRW MXN PEN PHP PLN RON RUB SGD THB TRY TWD ZAR USD Sep -2% -3% 9% -3% -3% -3% -3% -5% 6% 2% -2% -5% -9% -3% -2% -3% -9% -6% -3% 12% -2% 36% Oct -2% -3% -6% -3% -3% -3% -4% -4% 7% 0% -1% -6% -12% -3% -2% -2% -9% -7% -3% 5% -2% 62% Nov -2% -3% -1% -3% -3% -3% -4% -5% 4% -3% 0% -4% -1% -3% -4% -2% -8% -7% -3% 0% -1% 57% Dec 2% 3% 6% -2% 3% 3% 4% -5% 8% 7% 3% 3% 12% -3% -5% -2% 9% 6% 1% 8% 2% -61% Jan 2% 3% -7% 3% 3% 3% -2% 5% 8% 5% 3% -3% 13% -3% -5% -2% 8% -4% -2% 8% -1% -35% Feb -1% 2% -6% -2% 3% 3% -4% 3% 9% 5% -2% -7% -16% -3% 5% 1% 7% -7% 2% 9% -2% 2% Mar -2% 3% 7% -3% 4% 3% -4% 3% 8% 4% -2% -2% -8% -3% -5% -3% 1% -8% 2% 11% 2% -9% Apr 0% 2% -2% -1% 3% 3% -3% 4% 8% 5% -1% -4% -3% -3% -2% -1% 5% -6% 1% 9% 0% -14% May -2% -3% -8% -2% -1% -4% -6% -5% -6% 4% -1% -3% -11% -4% -1% -3% 8% -7% -1% -7% -2% 64% Jun 0% -3% -8% -2% 4% 3% -6% -5% -7% -1% 3% -2% -11% 3% 6% -3% 6% -7% -1% -6% -3% 40% Jul 3% -3% -9% -3% 4% 1% -7% -6% -8% 2% -3% -2% -7% 3% -3% 4% -8% -7% -2% -7% -3% 60% Aug -2% -3% -8% -3% 4% -2% -7% -6% 7% -5% -3% -2% -5% 0% -5% 3% -8% -8% -2% -8% -3% 65% Source: Morgan Stanley Research, Bloomberg. Percentages represent the average exposure of the strategy in each currency forward.for the given month. Exhibit 147: FX Equity Momentum Positioning, developed markets, year to date Month AUD CAD CHF EUR GBP JPY NOK NZD SEK USD Sep -9% -5% -7% -13% -10% -14% -7% -4% -3% 71% Oct -9% -13% -13% -13% -9% -5% -6% -9% -2% 79% Nov -9% -14% -15% -14% -9% 10% -6% -9% -9% 74% Dec 9% 8% -15% 15% 10% 13% 4% 5% 10% -59% Jan 9% -8% -15% -15% -8% 9% -6% -9% -9% 52% Feb 9% -11% -15% 9% -9% 15% 4% -9% 10% -2% Mar 1% 13% -14% -14% 3% -17% 1% -8% 9% 26% Apr -8% -17% -9% -17% -8% -9% -6% -9% -12% 95% May -8% 13% -13% 14% 9% -16% 8% -8% 9% -9% Jun -9% 14% 10% 14% 11% -16% 1% -8% 2% -20% Jul -9% 12% 11% -13% -12% -19% -7% -8% -9% 54% Aug -10% -10% 13% -16% -12% -14% -7% -9% -10% 75% Source: Morgan Stanley Research, Bloomberg. Percentages represent the average exposure of the strategy in each currency forward for the given month. 85 In Case You Missed It Global Macro Strategist: Stay Short UST, Long USD 06 Aug 2021 10y UST yields double-bottomed at 1.125% and will rise into year-end, led by US real rates decoupling from those in Europe. Strong US data, back-to-school success, "advanced notice" on Fed tapering, and progress on infrastructure make the US stand out. Stay short UST duration, long the USD. Global Macro Strategy: ECB Purchase Programmes Update 02 Aug 2021 We highlight key statistics and monthly activity across the ECB asset purchase programmes, focusing on the PSPP and PEPP. Global Macro Strategy: Europe's Real Rates Get Revenge 02 Aug 2021 In July 2020, expectations for the Fed's strategy review and dovish forward guidance drove US real rates lower, which dragged real rates lower in Europe. In July 2021, real rates in Europe got revenge by dragging US real rates lower, helped by COVID-19 developments and dovish ECB strategy. Sunday Start | What's Next in Global Macro: Yields Are "a Ways Off" Where They Should Be 01 Aug 2021 Citius, Altius, Fortius – the Olympic motto – which translates to Faster, Higher, Stronger, might as well be our current motto for Treasury yields. We think that the Treasury market will price in a faster pace of rate hikes, resulting in higher US 10-year yields, consistent with a stronger economy. 86 Forecasts Government bonds Exhibit 148: Morgan Stanley sovereign 2y, 5y, 10y, and 30y yield base case forecasts 2Y 5Y 10Y 30Y 3Q21 4Q21 1Q22 2Q22 3Q21 4Q21 1Q22 2Q22 3Q21 4Q21 1Q22 2Q22 3Q21 4Q21 1Q22 2Q22 US Germany Japan UK Canada Australia New Zealand Austria* Netherlands* France* Belgium* Ireland* Spain* Italy* Portugal* 0.25 0.25 0.30 0.35 0.80 0.85 0.95 1.10 1.70 1.80 1.90 2.00 2.40 2.45 2.45 2.55 -0.65 -0.65 -0.60 -0.60 -0.55 -0.50 -0.45 -0.40 -0.20 -0.15 -0.10 0.00 0.35 0.40 0.45 0.50 -0.10 -0.10 -0.10 -0.10 -0.10 -0.10 -0.10 -0.05 0.15 0.15 0.15 0.20 0.70 0.70 0.70 0.75 0.15 0.20 0.25 0.25 0.50 0.55 0.60 0.65 0.90 1.00 1.05 1.10 1.45 1.55 1.60 1.65 0.45 0.55 0.70 0.85 1.10 1.20 1.30 1.40 1.65 1.75 1.80 1.90 2.15 2.25 2.35 2.40 0.10 0.10 0.10 0.10 0.90 1.00 1.10 1.20 1.85 1.95 2.10 2.30 2.50 2.60 2.60 2.65 0.25 0.50 0.65 0.75 0.95 1.10 1.25 1.35 1.85 1.90 1.95 2.00 5 5 5 5 10 5 5 5 15 10 5 5 25 20 20 20 0 0 0 0 0 0 0 0 5 5 5 0 5 5 5 5 5 5 5 5 5 5 5 5 30 25 20 15 40 35 30 30 5 5 5 5 5 5 5 5 25 20 20 15 40 35 30 30 10 5 5 5 10 5 5 5 25 20 15 15 40 35 30 30 15 10 10 10 35 30 25 25 60 55 50 50 95 85 80 75 30 25 20 15 70 65 60 55 100 90 85 80 135 125 115 105 15 10 10 10 30 25 20 20 55 50 45 45 90 85 80 75 Source: , Morgan Stanley Research, *Spread to German Bunds Exhibit 149: Morgan Stanley sovereign 10-year yield bull, base, and bear case forecasts Bull Base Bear 3Q21 4Q21 1Q22 2Q22 3Q21 4Q21 1Q22 2Q22 3Q21 4Q21 1Q22 2Q22 US Germany Japan UK Canada Australia New Zealand 1.35 1.45 1.60 1.70 1.70 1.80 1.90 2.00 1.80 1.95 2.05 2.20 -0.45 -0.50 -0.45 -0.45 -0.20 -0.15 -0.10 0.00 -0.10 0.00 0.15 0.25 0.00 0.05 0.10 0.15 0.15 0.15 0.15 0.20 0.15 0.15 0.20 0.25 0.50 0.40 0.30 0.25 0.90 1.00 1.05 1.10 1.10 1.20 1.30 1.35 1.40 1.45 1.50 1.60 1.65 1.75 1.80 1.90 1.70 1.90 2.05 2.15 1.60 1.60 1.65 1.80 1.85 1.95 2.10 2.30 1.90 2.00 2.10 2.20 1.45 1.30 1.20 1.10 1.85 1.90 1.95 2.00 1.90 2.00 2.10 2.20 Austria* Netherlands* France* Belgium* Ireland* Spain* Italy* Portugal* 5 5 0 0 15 10 5 5 35 40 45 50 0 0 -5 -5 5 5 5 0 30 35 40 50 15 10 10 5 30 25 20 15 55 65 80 85 10 10 5 5 25 20 20 15 50 60 75 80 20 15 10 10 25 20 15 15 70 85 100 110 45 35 30 25 60 55 50 50 90 100 110 120 85 75 65 55 100 90 85 80 145 155 170 260 45 30 25 25 55 50 45 45 95 105 115 125 Source: Morgan Stanley Research, *Spread to German Bunds 87 Foreign exchange Exhibit 150: Morgan Stanley foreign exchange base case forecasts EUR/USD USD/JPY GBP/USD USD/CHF USD/SEK USD/NOK USD/CAD AUD/USD NZD/USD EUR/JPY EUR/GBP EUR/CHF EUR/SEK EUR/NOK USD/CNY USD/HKD USD/IDR USD/INR USD/KRW USD/MYR USD/PHP USD/SGD USD/TWD USD/THB USD/BRL USD/MXN USD/ARS USD/CLP USD/COP USD/PEN USD/ZAR USD/TRY USD/ILS USD/RUB EUR/PLN EUR/CZK EUR/HUF DXY Fed's Broad USD Index 3Q21 1.22 109 1.43 0.92 8.28 8.03 1.19 0.77 0.73 133 0.85 1.12 10.10 9.80 6.45 7.75 14150 73.5 1105 4.09 47.6 1.32 27.7 30.9 5.25 20.00 104 695 3800 3.65 14.5 8.38 3.22 73.8 4.46 25.1 352 90 111 4Q21 1.21 110 1.40 0.93 8.35 8.10 1.21 0.77 0.74 133 0.86 1.12 10.10 9.80 6.48 7.75 14300 74.0 1120 4.12 48.0 1.33 27.8 31.1 5.30 20.40 123 710 3900 3.60 14.8 8.54 3.25 74.8 4.42 24.8 348 91 112 Source: Morgan Stanley Research. Click here for custom cross forecasts 1Q22 1.19 111 1.41 0.95 8.66 8.32 1.23 0.76 0.74 132 0.85 1.13 10.30 9.90 6.53 7.75 14500 74.8 1130 4.15 48.3 1.34 28.0 31.2 5.30 20.80 137 705 3950 3.55 14.8 8.59 3.24 74.8 4.37 24.8 344 92 114 2Q22 1.18 112 1.41 0.97 8.81 8.47 1.23 0.75 0.75 132 0.84 1.14 10.40 10.00 6.55 7.75 14700 75.4 1140 4.18 48.6 1.35 28.2 31.5 5.40 21.00 147 700 4000 3.50 15.3 9.02 3.26 75.9 4.39 25.2 346 93 115 3Q22 1.20 109 1.42 0.95 8.53 8.40 1.23 0.78 0.76 131 0.85 1.14 10.27 10.11 6.47 7.75 14482 74.9 1116 4.07 48.4 1.33 28.2 31.1 5.60 20.41 155 687 3762 3.49 14.9 9.25 3.26 72.8 4.39 25.6 346 91 113 4Q22 1.23 107 1.43 0.93 8.26 8.33 1.23 0.81 0.77 131 0.86 1.14 10.13 10.21 6.40 7.75 14264 74.4 1092 3.97 48.3 1.32 28.3 30.6 5.40 19.81 168 673 3525 3.48 14.5 9.50 3.26 69.8 4.39 26.0 345 90 111 88 Exhibit 151: Morgan Stanley foreign exchange Base, Bear, Bull scenarios 2Q22 Bear EUR/USD 1.14 GBP/USD 1.36 USD/JPY 104 AUD/USD 0.68 USD/CNY 6.20 USD/INR 71.0 USD/ZAR 14.8 USD/BRL 5.00 USD/MXN 19.75 Source: Morgan Stanley Research Base 1.18 1.41 112 0.75 6.55 75.4 15.3 5.40 21.00 Bull 1.26 1.53 114 0.78 6.75 78.0 16.9 6.00 22.30 Trade Ideas Interest Rate Strategy TRADE Receive November RBNZ Long 10y Bunds vs UST Short US 10y Long BAZ2 5s30s ACGB Steepener Below you will find a list of our current trade ideas, entry levels, entry dates, rationales, and risks. ENTRY LEVEL ENTRY DATE RATIONALE RISKS 6-Aug-21 We think RBNZ pricing is modestly aggressive and the RBNZ's projections may only imply two hikes this year, compared to nearly 3 hikes priced into the market, at the upcoming August RBNZ meeting. The key risk is that RBNZ projections imply three hikes this year or that teh bank hikes 50bp at the August meeting. 170bp 23-Jul-21 We think the increasing divergence that is starting to take place between the Fed and the ECB will likely favour Bund outperformance on the back of the central bank reaction function divergence theme. In our opinion, the current level of the spread is not consistent with central bank pricing. The key risks to this trade are deterioration of the virus situation, seasonality, and on the margin less ECB support during the summer. 135bp 9-Jul-21 We suggest going short 10y Treasuries to position for higher nominal yields in the belly of the curve. Participants seem to be questioning the rally in Treasuries as a reflection of rising concerns about the Delta variant of the virus, and even suggesting that the Fed wasn't really hawkish to begin with. We maintain, based on evidence, that the decline in Treasury yields is largely explained by positioning unwinds, and therefore likely to reverse. The key risks to this trade are deterioration of the virus situation or growth disappointing. 98.81 25-Jun-21 Market pricing implies BoC liftoff unrealistically early - and much sooner than the BoC's current guidance. We also expect the post-liftoff pace of hikes from the BoC to more closely resemble those of the Fed than currently implied by market pricing. The key risk to this trade is that inflation rises quickly in Canada, leading the BoC to tighten policy sooner than markets expect. 146bp 25-Jun-21 We think the move higher in RBNZ policy The key risks to the trade are that the Fed sounds expectations is aggressive but less implausible incrementally more hawkish at upcoming meetings than the corresponding move in RBA pricing. We or the RBA unexpectedly does not extend its QE recommend 5s30s steepeners in Australia, where program. the RBA has a significantly more dovish reaction function than the RBNZ. 89 30y OAT -Bund tightener Buy 10y Italy vs Spain Long Ireland 10y vs 10y France Underweight 10y UST and 10y DBR vs 10y UKT and 10y ACGB Currency and Foreign Exchange TRADE Short CHF/NOK Long AUD/NZD 69bp 25-Jun-21 We think that 30y France could outperform Germany as political risk from regional elections subsides and with France returning to trade more in line with core. The main risk is that the French Treasury comes with a 30y syndication in July. 46.4bp 16-May-21 We see scope for Italy’s outperformance over Spain as Italy is expected to re-converge faster to its 2019 level of output, with the higher take-up of NGEU loans and grants money so far requested helping the country in outperforming. Delay in Recovery Fund disbursement or an anticipation of tapering by the ECB could push the spread wider. 6.5bp 22-Jan-21 In 2021, we look for Irish bonds to reverse 2H 2020 Currently, Ireland has one of the higher Covid underperformance, which was likely due in part to infection rates in the world, potentially meaning a Brexit uncertainty. In addition, supply schedule longer period in Level 5 restrictions and additional favours Irish outperformance vis a vis France. government spending measures/issuance. Additionally, our view that Ireland has completed the majority of its 10-year issuance could prove wrong in future quarterly remits. -22.6bp 10-Jun-20 In the US, a fast economic recovery along with an Growing delta variant fears or global economic even higher expectation for supply could drive the growth concerns would lead to flows to safe haven curve steeper, while in Germany the skew for Bunds assets, which in turn would support US Treasuries appears to be higher in the light of the creation of a and Bunds more than UK gilts and Australian bonds. substitute AAA rated EU debt for financing SURE and These flows would flatten the US and German Next Generation EU in 2020 and 2021, respectively. curves more than those in the UK and Australia. In relative terms, in the UK the curve should flatten more on the expectation of NIRP and easy MPC policy, while in Australia the relative demand driven by RBA and foreign investors should help the curve to steepen less than US and German curves. ENTRY LEVEL ENTRY DATE RATIONALE RISKS 9.5810 1.0481 13-Aug-21 CHF should weaken as US real yields rise, and short positioning is now cleaner in the options market as well. In contrast, NOK should benefit from a steepening in the US yield curve. The rates market is now pricing in a more gradual rate hiking cycle than signalled by Norges Bank, which we expect will remain hawkish and continue to signal a frontloaded rate hike cycle at its meeting on August 19. There is thus room for markets to bring forward their pricing of hikes. NOK is also trading cheap versus oil prices, and long positioning in NOK/SEK is cleaner now after the 6% weakness since April. 6-Aug-21 We think the RBA's hawkish August meeting suggests that monetary policy may continue to turn more hawkish over time but that fiscal policy may be the marginal stimulus measure in response to COVID 19 lockdowns, and expansionary fiscal policy and austere monetary policy tends to be currency positive. Meanwhile, the RBNZ pricing is marginally too hawkish, in our view. Significant sell-off in risk appetite, which should weigh on NOK and support CHF. The key risk is that the RBNZ hikes more than markets expect or that the RBA turns more dovish. 90 Long USD versus CLP, BRL, and MXN Long USD/JPY vs selling 3m 112.50 USD/JPY call Long USD/CHF 1y risk reversal (buy 0.9450 call, sell 0.8850 put) Short EUR/USD Inflation-Linked Bonds TRADE Short beta-weighted 10y breakevens (Dv01 0.7 : 1) Short-Duration Strategy TRADE EDZ2Z4 steepener Z1/Z2 FRA/OIS flattener 100.0000 6-Aug-21 We keep our bearish view on LatAm currencies and keep long USD exposure via an equally-weighted basket of long USD versus BRL, CLP, and MXN. We replace our previous short COP exposure with short BRL, given expensive valuations for the real, rising fiscal risks, and already ambitious BCB market pricing. We also see attractive risk/reward in short CLP positions, given ongoing political uncertainty, a weaker outlook for metal prices, and low carry. Lastly, we think that asymmetric USD risks and fairly ambitious market pricing for Banxico’s hiking cycle point to increasing risks for MXN. A weaker USD. 110.28, 0.4% 18-Jun-21 We expect "Regime 3" of our USD framework on the back of the hawkish Fed, but see risk remaining resilient given ample liquidity. We see JPY underperforming as a funding currency, while USD should go higher as markets price in a more hawkish Fed. Significant risk-off resulting in demand for safe haven currencies. The Fed turning dovish again, leading to broader USD weakness. 0.21% 18-Jun-21 We expect the USD rally to continue and CHF to be US economic data start to underperform, which one of the biggest underperformers within the G10. causes US real yields to fall again and the market to Leveraged funds are very long CHF. Front-end re-engage in short USD positions. implied volatility has risen with the bigger spot moves recently, making 1y vol a bit more attractive. 1.2100 4-Jun-21 We suggest selling EUR/USD as a way to play for upcoming USD upside risks. The pair has struggled to break above 1.22 despite several EUR-positive developments, suggesting long positioning is posing headwinds for the currency and putting the focus on the USD leg. Increasing central bank divergence (as the ECB continues to sound dovish), PBoC concerns about CNY appreciation, a US inflation disappointment that pushes US real yields higher and breakevens lower, and the Fed moving closer toward reducing the pace of its asset purchases all raise the prospects of USD strength in coming months. Global growth significantly outperforms or US growth momentum slows, pushing US real yields lower and generating broad USD weakness. ENTRY LEVEL ENTRY DATE RATIONALE RISKS 208bp 14-May-21 We think breakevens are too high and real yields are The risk is that breakevens continue to widen while too low relative to nominal yields. real rates stay low. ENTRY LEVEL ENTRY DATE RATIONALE RISKS 104bp 25-Jun-21 We think EDZ2Z4 steepeners offer positive asymmetry. We think the timing of the first hike in December 2022 has limited room to move in earlier than December 2022, which means it will be difficult for the EDZ2 contract to sell off if economic data are strong (as they are according to our analysis), while EDZ4 has more room to sell off. We therefore expect a bear steepening of the curve if data beat expectations. This trade could underperform if the market begins to price in Fed rate hikes sooner than December 2022, or if the market expects fewer rate hikes following the initial hike. 3.88 11-Jun-21 With (1) higher GSIB surcharges leading to uncertain If FRA/OIS compresses even further, the curve could bank balance sheet practices, (2) the potential for steepen as nearer contracts will likely experience SLR constraints to materialize, and (3) expected more of the impact. increases to T-bill issuance in 4Q, we think there is good risk/reward in positioning for this year-end to widen out. 91 Buy 6m T-bills vs OIS EDM2EDM3 Flattener USD/JPY basis 2s10s steepener Pay USD/JPY basis 10y10y Interest Rate Derivatives TRADE 10s30s swap spread flattener, PV01-neutral Buy 6m10y ATMF +10bp payer, sell 6m10y ATMF+50bp payer and 6m10y ATMF-20bp receiver Buy 20y JGB ASW against 3mDTIBOR or TONA OIS Short 3m10s30s ATMF curve straddle, long 3m10y ATMF straddle, deltahedged Pay 2y1y TONAOIS Buy ATMF 3m5y payer (1.02%), Sell ATMF+10bp and ATMF+15bp 3m5y payers (1.12% / 1.17%), buy ATMF+33bp 3m5y payer (1.35%) -6bp 21-May-21 We expect significant paydowns of T-bills to occur in 2021, especially headed into the debt ceiling. With reserves continuing to increase alongside Fed QE and a drawdown in the TGA, demand for T-bills will likely increase as supply decreases, leading to a richening of bills across the curve. The trade carries positively the life of the trade. If stimulus is significantly larger than expected, there will likely be increased issuance of T-bills, which could lead to modest cheapening. 41.5bp 26-Feb-21 This trade positions for a fade in the market pricing of Fed hikes. We prefer this curve expression over an outright long in EDM3, as the curve is unlikely to react to changes in FRA/OIS. Additional market pricing of Fed hikes in 2022 and 2023. -13bp 26-Feb-21 We expect USD/JPY basis curve to steepen going forward and enter USD/JPY basis 2s10s steepeners, with spreads at the short end looking to be at heightened risk of widening on the back of concern about hawkish Fed pricing, while longer- dated basis swaps should continue to be paid for yield enhancement and deal-related demand. Worsening of financial conditions lead to the wider credit spread. -54bp 20-Nov-20 Further tightening of global credit spreads and demand for carry. Deal-related receiving flow in the longer end. Worsening credit conditions. ENTRY LEVEL ENTRY DATE RATIONALE RISKS -30bp 13-Aug-21 We think 30y UST issuance will increase relative to issuance in the belly, which will bias 30y spreads lower. Also, our fair value models for spreads view 30y spreads about 6bp wider than fair value 30y spreads widen as a result of swaps underperforming Treasuries, or 10y spreads rally by more than 30y spreads 0c 6-Aug-21 Trade positions for higher rates in the medium term, while selling out-of-the-money options to make the structure zero-cost. Trade has attractive payout at 10y rate levels around 1.8%, in line with our base case. Another rally in UST yield beyond 1.05% would cause the trade to lose money. 20 bp/ 15.25 bp 23-Jul-21 20y JGB ASW are trading at very cheap levels, and we see decent demand from city banks to purchase 20y JGB in the event of any sell-off. Our rates strategists are currently bearish on UST yields since the current UST rally is mostly driven by technicals rather than reflecting the change in fundamentals. Another rally in UST yield. 0c 16-Jul-21 The trade would perform well if 10s30s curve remained fairly rangebound over the next few months while 10y rates experienced increased volatility. The trade would struggle if 10y rates and 30y rates became less correlated over the near term. -9.6bp 16-Jul-21 The belly of TONA OIS curve looks to rich vs fixing, and TONA fixing would likely move higher. Market price in rate cut. 0c 18-Jun-21 Rates could move higher if the market continues to If 5y rates sell off dramatically in the short term, this price in a more hawkish Fed; this trade positions for trade will lose money, though the ATMF+33bp payer 5y rates to sell off 15-20bp vs. the forwards. provides some downside protection. 92 Sell 2m10y ATMF straddle and buy 0.6x 5m10y ATMF straddle Buy 10yJGB ASW against 3m DTIBOR Pay 5y ZTibor-Libor basis ZTIBOR-OIS 5s20s flattener US 1y30y 1x1 payer spread (2.04%/2.34%) US 6m5y 1x2 payer spread (0.89%/1.19%) 0c 4-Jun-21 Public policy announcements could support vol later Sooner-than-expected progress on major policy in the year, while we expect implied vols to trade flat events, including potential news on a Fed leadership to lower in the near term. changes, the debt ceiling, expiration of unemployment benefits, and infrastructure headlines, could cause this trade to underperform. 0.5bp 4-Jun-21 The level of 3m DTIBOR swap looks stretched, and this position provides the attractive carry. Further receiving demand for 3m DTIBORreferencing swap from Japanese banks' ALM department. -6.375bp 4-Jun-21 The level looks stretched, and we expect loan hedge-related paying to dominate the market towards June-end as seasonality suggested. Further receiving demand for TIBOR-LIBOR basis from Japanese banks' ALM department. 11bp 9-Apr-21 ZTIBOR are expected to discontinue on Dec-2024, Another loan swap hedge-related paying in the long and we expect the market to start to price in the end. expected fallback spread. 2.90% 26-Feb-21 This trade takes advantage of elevated payer skew If back-end rates rally or vol increases, this trade will and captures a distribution of rates that we believe not perform. will occur under our base case. 0c 26-Feb-21 6m5y 1x2 payer spreads position well for a move (even an unexpectedly large move higher) in 5y yields, given the extremely rich levels of payer skew, as well as the fact that the 5y point has the most implied yield curve control. 5y rates sell off by more than 40bp in the next six months or if payer skew and vol richen further. Exhibit 152: History of recommendations Buy 1y USD/CHF risk reversal, buy 0.9450 call, sell 0.8850 put Instrument Maturity Trade USD/IDR USD/INR USD/BRL USD/MXN USD/ZAR USD/CHF USD/CHF USD/JPY USD/JPY 12m Long EMFX (IDR, INR, BRL, MXN, ZAR) vs. CHF, JPY 12m Long EMFX (IDR, INR, BRL, MXN, ZAR) vs. CHF, JPY 12m Long EMFX (IDR, INR, BRL, MXN, ZAR) vs. CHF, JPY 12m Long EMFX (IDR, INR, BRL, MXN, ZAR) vs. CHF, JPY 12m Long EMFX (IDR, INR, BRL, MXN, ZAR) vs. CHF, JPY - Long EMFX (IDR, INR, BRL, MXN, ZAR) vs. CHF, JPY 12m Long EMFX (IDR, INR, BRL, MXN, ZAR) vs. CHF, JPY - Long EMFX (IDR, INR, BRL, MXN, ZAR) vs. CHF, JPY 12m Long EMFX (IDR, INR, BRL, MXN, ZAR) vs. CHF, JPY Long USD/JPY outright with selling 3m USD/JPY call at 112.50 Instrument Maturity Trade USD/JPY USD/JPY Source: Morgan Stanley Research 3m Sell 3m 103-107 USD/JPY strangle 1.5% 3m Sell 3m 103-107 USD/JPY strangle Entry Date 15-Nov-20 15-Nov-20 15-Nov-20 15-Nov-20 15-Nov-20 15-Nov-20 15-Nov-20 15-Nov-20 15-Nov-20 Entry Level 14721 77.6 5.5236 21.3491 16.1953 0.9155 -100.45 105.52 -54.8 Exit Date 15-Jan-21 15-Jan-21 15-Jan-21 15-Jan-21 15-Jan-21 15-Jan-21 15-Jan-21 15-Jan-21 15-Jan-21 Exit Level 14589 76.45 5.4078 20.5999 15.7831 0.8896 -96.75 104 -51.82 Target/ Objective Stop/Re- Size of Trade or assess Unit/Notional Entry Date 2-Oct-20 14-Oct-20 Entry Level 1.50% 1.50% Exit Date 04-Jan-21 11-Nov-20 Exit Level 0.00% 0.80% Target/ Objective Stop/Re- Size of Trade or assess Unit/Notional CUSIP/ISIN/ BLOOMBERG IRN+12M Curncy IRN+12M Curncy BCN+12M Curncy MXN+12M Curncy ZAR+12M Curncy USDCHF Curncy CHF12M Curncy USDJPY Curncy JPY12M Curncy CUSIP/ISIN/ BLOOMBERG USDJPY Curncy USDJPY Curncy Definition of terms Buy/Long: The analyst expects the total or excess return (depending on the nature of the recommendation) of the instrument or issuer that is the subject of the investment recommendation to be positive over the relevant time period. Sell/Short: The analyst expects the total or excess return (depending on the nature of the recommendation) of the instrument or issuer that is the subject of the investment recommendation to be negative over the relevant time period. Selling protection or Buying Risk: The analyst expects that the price of protection against the event occurring will decrease over the relevant time period. Buying protection or Selling Risk: The analyst expects the price of protection against the event occurring will increase over the relevant time period. Pay: The analyst expects that over the specified time period the variable rate underlying the swap agreement that is the subject of the investment recommendation will increase. Receive: The analyst expects that over the specified time period the variable rate underlying the swap agreement that is the subject of the investment recommendation 93 will decrease. Unless otherwise specified, the time frame for recommendations included in the Morgan Stanley Fixed Income Research reports is 1 - 3 months and the price of financial instruments mentioned in the recommendation is as at the date and time of publication of the recommendation. When more than one issuer or instrument is included in a recommendation, analyst expects one part of the trade to outperform the other trade or combination of other trades included in the recommendation on a relative basis. For important disclosures related to the proportion of all investment recommendations over the past 12 months that fit each of the categories defined above, and the proportion of issuers corresponding to each of those categories to which Morgan Stanley has supplied material services, please see the Morgan Stanley disclosure at https://ny.matrix.ms.com/eqr/article/webapp/22d0c63e-e30f-11eb-bf5a-9db5a7ed0efb 94 Event Calendar Exhibit 153: Risk Event Calendar Date Time (Ldn) Ccy Event 15-Aug 16:30 ILS CPI (YoY) 23:30 NZD Performance Services Index 16-Aug 00:01 00:50 GBP Right Move House Prices (YoY) JPY GDP (QoQ) 02:30 03:00 03:00 03:00 03:00 03:30 05:30 CNY New Home Prices (MoM) CNY Retail Sales (YoY) CNY Industrial Production (YoY) CNY Fixed Assets Ex Rural YTD (YoY) CNY Unemployment Rate THB GDP (YoY) JPY Industrial Production (MoM) 07:00 07:30 09:00 11:00 13:00 13:30 13:30 NOK Trade Balance INR Wholesale Prices (YoY) CHF SNB Sight Deposits ILS GDP (QoQ) PLN CPI Core (YoY) UAH GDP (YoY) CAD Manufacturing Sales (MoM) 16-20 A 13:30 13:30 14:00 15:30 21:00 N/A N/A USD Empire Manufacturing CAD Wholesale Trade Sales (MoM) CAD Existing Home Sales (MoM) CAD BoC Senior Loan Officer Survey USD Total Net TIC Flows PEN GDP (YoY) USD Mortgage Delinquencies 16-20 A N/A USD MBA Mortgage Foreclosures 17-Aug 00:30 01:30 02:30 05:30 AUD Consumer Confidence SGD Non-Oil Domestic Exports (YoY) AUD RBA Minutes JPY Tertiary Industry Index (MoM) 07:00 07:00 07:00 07:00 07:00 08:00 08:30 GBP Jobless Claims Change GBP Average Weekly Earnings (Inc. Bonuses, 3M/Y) GBP ILO Unemployment Rate 3Mths GBP Employment Change (3M/3M) RON GDP (YoY) HUF GDP (YoY) EUR Netherlands GDP (QoQ) 10:00 N/A 13:15 13:30 EUR Eurozone GDP (QoQ) NZD Global Dairy Trade Announces Milk Auction Results CAD Housing Starts USD Retail Sales Advance (MoM) Ref. Period Jul Jul Aug 2Q P Jul Jul Jul Jul Jul 2Q Jun F Jul Jul 2Q A Jul 2Q P Jun Aug Jun Jul Jun Jun 2Q 2Q Jul Aug-03 Jun Jul Jun Jun Jun 2Q A 2Q P 2Q P 2Q P Jul Jul MS forecast 0.2% 10.4% 7.8% 11.1% 7.5% 11.0% 3.6% 10.2% 2.0% 7.2% 4.9% 128k 16.0% 1.1% 2.0% -0.4% Market 1.8% 0.5% 10.9% 7.9% 11.3% 5% 6.4% 11.29% 12.6% 3.6% 7.3% 28.5 11.9% 1.8% 8.6% 4.8% 100k 14.5% 15.9% 1.5% 2% 275k -0.3% Previous 1.7% 58.6 5.7% -3.9% 0.41% 12.1% 8.3% 12.6% 5% -2.6% 6.2% 25.02B 12.07% 713.2B -5.8% 3.5% -2.2% -0.61% 43 0.5% -8.4% 105.3B 47.8% 6.38% 0.54% 98.6 15.9% -0.8% -114.75k 7.3% 4.8% 25k -0.2% -2.1% -0.5% 2% 282k 0.6% 95 17-20 A 18-Aug 19-Aug 13:30 13:30 14:15 14:15 14:15 15:00 15:00 17:00 17:00 18:30 20:45 N/A 00:50 00:50 00:50 01:30 02:10 02:30 03:00 03:00 04:00 07:00 07:00 09:00 09:00 10:00 10:00 10:00 13:30 13:30 13:30 13:30 13:30 15:30 19:00 23:00 00:50 02:30 02:30 07:30 07:30 08:20 09:00 09:00 09:00 09:30 09:30 13:30 USD Retail Sales Ex Auto (MoM) Jul USD Retail Sales Control Group (MoM) Jul USD Industrial Production (MoM) Jul USD Capacity Utilization Jul USD Manufacturing Production (MoM) Jul USD Business Inventories Jun USD NAHB Housing Market Index Aug COP GDP (YoY) 2Q COP Economic Activity Index (YoY) Jun USD Fed's Powell (voter) spks (Town Hall Discussion with Educators) USD Fed's Kashkari (non-voter) spks CNY National People's Congress Standing Committee JPY Trade Balance Jul JPY Exports (YoY) Jul JPY Machine Orders (MoM) Jun AUD Westpac Leading Index (MoM) Jul JPY BoJ Outright Bond Purchase 1-3y, 3-5y, 5-10y AUD Wage Price Index (QoQ) 2Q NZD RBNZ Rates Decision NZD RBNZ Monetary Policy Statement NZD RBNZ Press Conference GBP CPI (YoY) Jul GBP CPI Core (YoY) Jul NOK Norway Sovereign Wealth Fund Semiannual Report 1H21 ZAR CPI (YoY) Jul EUR CPI (YoY) Jul F EUR CPI Core (YoY) Jul F EUR Construction Output (MoM) Jun CLP GDP (YoY) 2Q CAD CPI (YoY) Jul USD Housing Starts Jul USD Housing Starts (MoM) Jul CAD Core CPI - Common (YoY) Jul USD EIA Crude Oil Inventories USD FOMC Minutes USD Fed's Kaplan (non-voter) spks (Global Economy) JPY Japan MoF Weekly Security Flow AUD Employment Change Jul AUD Unemployment Rate Jul NOK Consumer Confidence 3Q CHF Industrial Production (YoY) 2Q IDR BI Rates Decision EUR Euro-Area Current Account Jun NOK Norges Bank Rates Decision EUR Spanish Trade Balance Jun EUR Italian Current Account Balance Jun NOK Norges Bank's Olsen spks (Economic Outlook) USD Philadelphia Fed Business Outlook Aug -0.1% -0.4% 0.4% 17.7% 0.2% -0.3% 0.5% 75.7% 0.6% 0.8% 80 18.3% 15.3% 1.3% 1.1% 0.4% 75.4% -0.1% 0.5% 80 1.1% 13.6% 110B 39.2% -2.8% 0.6% 177.3B 39% -3% 0.6% 0.5% 384B 48.6% 7.8% -0.07% 0.59% 0.25% 2.4% 2.2% 4.6% 2.2% 0.7% 17.2% 1507k -8.3% 2.3% 2.1% 4.7% 2.2% 0.7% 3.4% 1600k -2.6% 1.8% 2.5% 2.3% 4.9% 2.2% 0.7% 0.9% 0.34% 3.1% 1643k 6.3% 1.7% -448k -30k 4.9% 3.50% 0.00% -46.2k 5% 3.5% 0% 24 615.7B 29.1k 4.9% 2.5 4.4% 3.5% 11.7B 0% 140.1 3882.1m 21.9 96 13:30 USD 15:00 USD 20:00 ARS N/A PEN 20-Aug 00:01 GBP 00:05 AUD 00:30 JPY 00:30 JPY 00:30 JPY 02:30 CNY 02:30 CNY 04:00 NZD 07:00 NOK 07:00 NOK 07:00 NOK 07:00 NOK 07:00 EUR 07:00 GBP 07:00 GBP 08:00 MYR 08:30 SEK 09:00 TWD 13:30 CAD Source: Morgan Stanley Research, Bloomberg Initial Jobless Claims Leading Index Economic Activity (YoY) GDP (YoY) GfK Consumer Confidence RBA's Kent spks (FX Markets Conference) CPI (YoY) CPI Ex Fresh Food (YoY) CPI Ex Fresh Food, Energy (YoY) 1-Year Loan Prime Rate 5-Year Loan Prime Rate Credit Card Spending (MoM) GDP (MoM) Mainland GDP (MoM) GDP (QoQ) Mainland GDP (QoQ) German PPI (YoY) Retail Sales (MoM) Public Sector Net Borrowing Foreign Reserves Capacity Utilization Export Orders (YoY) Retail Sales (MoM) Jul 0.75% Jun 2Q 40.6% Aug 360k 375k 0.7% 0.7% 13.6% 3.8% -7 -7 Jul -0.4% -0.4% -0.5% Jul -0.4% -0.4% -0.5% Jul -0.8% -0.8% -0.9% 3.85% 3.85% 4.65% 4.65% Jul -1% Jun 1.2% Jun 1.3% 1.8% 2Q -0.6% 2Q 1.2% 1.5% -1% Jul 9.5% 9.2% 8.5% Jul 0.1% 0.2% 0.3% Jul 12.0B 11B 22B 111.1B 2Q 89.4% Jul 21.1% 31.1% Jun 5% -5.6% 97 Government Bond Ratings Exhibit 154: Government Bond Ratings Below no Aaa/ Aa1/ Aa2/ Aa3/ A1/ AAA AA+ AA AA- A+ A2/ A A3/ Baa1/ Baa2/ Baa3/ Ba1/ Ba2/ Ba3/ B1/ A- BBB+ BBB BBB- BB+ BB BB- B+ B2/ B B3/ B- B3/ B- Moody STA US S&P STA Fitch STA Moody STA JPN S&P STA Fitch STA Moody STA UK S&P NEG Fitch STA Moody STA GER S&P STA Fitch STA Moody STA FRA S&P STA Fitch NEG Moody STA AUT S&P STA Fitch STA Moody STA NETH S&P STA Fitch STA Moody STA FIN S&P STA Fitch STA Moody STA BEL S&P STA Fitch NEG Moody STA SPA S&P POS Fitch STA Moody STA ITA S&P NEG Fitch STA Moody STA IRE S&P STA Fitch STA Moody STA POR S&P STA Fitch STA Moody STA GRE S&P POS Fitch STA Australia Moody STA S&P STA Fitch STA New Zealand Moody S&P Fitch Moody S&P STA STA STA POS STA Canada Fitch STA Source: Morgan Stanley Research, Moody's, Standard and Poor, Fitch STA: Outlook Stable, NEG: Outlook Negative, DEV: Outlook Developing, OW-: On Watch Negative, POS: Outlook Positive, SD: Selective Default 98 Global Macro Strategy Team MORGAN STANLEY & CO. LLC Matthew Hornbach Matthew.Hornbach@morganstanley.com Guneet Dhingra, CFA Guneet.Dhingra@morganstanley.com Edward von der Schmidt, CFA Kelcie Gerson David Harris Henry Steck David Adams, CFA David.Adams@morganstanley.com Andrew Watrous Simon Waever Simon.Waever@morganstanley.com Andres Jaime Andres.Jaime@morganstanley.com Ioana Zamfir Gilberto Hernandez-Gomez MORGAN STANLEY & CO. INTERNATIONAL PLC James K. Lord James.Lord@morganstanley.com Alina Zaytseva Lorenzo Testa Sheena Shah Sheena.Shah@morganstanley.com Gek Teng Khoo John Kalamaras Pascal Bode Filip Denchev MORGAN STANLEY ASIA LIMITED+ Min Dai Min.Dai@morganstanley.com Belle Chang Jingzhong Zhang MORGAN STANLEY MUFG SECURITIES CO., LTD. Koichi Sugisaki Koichi.Sugisaki@morganstanley.com Shoki Omori Global Head of Macro Strategy Head of US Interest Rate Strategy US Interest Rate Strategist US Interest Rate Strategist US Interest Rate Strategist US Interest Rate Strategist Head of G10 FX Strategy, North America G10 FX Strategist Global Co-Head of EM Sovereign Credit Strategy Head of Latam Macro Strategy Latam Macro Strategist Latam Macro Strategist Global Head of FXEM Strategy European Interest Rate Strategist European Interest Rate Strategist Head of G10 FX Strategy, Europe G10 FX Strategist G10 FX Strategist EM Sovereign Credit Strategist CEE Macro Strategist Head of AXJ Macro Strategy AXJ Macro Strategist AXJ Macro Strategist Head of Japan Macro Strategy Japan Macro Strategist +1 212 761-1837 +1 212 761-1445 +1 212 761-7085 +1 212 761-3983 +1 212 761-0087 +1 212 761-3168 +1 212 761-1481 +1 212 761-5287 +1 212 296-8101 +1 212 296-5563 +1 212 761-4012 +1 212 296-8940 +44 20 7677-3254 +44 20 7677-1120 +44 20 7677-0337 +44 20 7677-6457 +44 20 7425-3842 +44 20 7677-2969 +44 20 7425-3282 +44 20 7677-3166 +852 2239-7983 +852 3963-0668 +852 2239-1528 +81 3 6836-8428 +81 3 6836-5466 99 Endnotes 1 The maximum 2021 pace for the RBA is quite high due to a brief period in February of this year when the RBA temporarily restarted YCC purchases in addition to QE purchases. That boosted purchases very temporarily by A$7bn/month (to $27bn) during a time when the RBA’s balance sheet was less than A$400bn total 2 "The heater" is slang for a fastball pitch, while a "change-up" is an off-speed pitch thrown at a slower velocity than a fastball. 100 Disclosure Section The information and opinions in Morgan Stanley Research were prepared or are disseminated by Morgan Stanley & Co. LLC and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan Stanley México, Casa de Bolsa, S.A. de C.V. and/or Morgan Stanley Canada Limited and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Europe S.E. and/or RMB Morgan Stanley Proprietary Limited and/or Morgan Stanley MUFG Securities Co., Ltd. and/or Morgan Stanley Capital Group Japan Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. 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