Goldman Sachs Group and Morgan Stanley have generated billions of dollars of revenue from fixed income trading over the last year, but that profit engine may have sputtered in the second quarter as bond markets grew turbulent.

Analysts have cut their earnings estimates for the two investment banks in recent weeks, citing concerns about fixed income trading, as well as merger advisory revenue and stock trading. The two banks are set to report results later this month.

The potentially weak results could be a blow for investors hoping that the banks' earnings would be returning to normality later this year or early next year.

All you are really doing is rewinding the camera -- we are going to replay the fixed income cycle, said Brad Hintz, an analyst with Sanford C. Bernstein. During that replay, fixed income gives up a lot of that profitability, especially on the credit side.

During the past year, Goldman relied heavily on a robust fixed income trading cycle to power record profit of $13.4 billion in 2009.

Even Morgan Stanley, which has lagged behind in its rebound from the financial crisis, beat Street expectations in the first quarter because of strong fixed income trading results.

Analysts are expecting a steep dropoff in Goldman's second-quarter earnings to $2.36 per share from $4.93 a year ago.

For Morgan Stanley, analysts are expecting earnings of 50 cents per share compared with a loss of $1.10 a year ago.

But analysts with the best track records are even more pessimistic. Goldman earnings could fall 8.5 percent below Wall Street estimates for the first quarter, according to StarMine's SmartEstimate, which weights estimates according to analysts' accuracy.

The SmartEstimate for Morgan Stanley is a downside surprise of 3.4 percent from estimates.

TRICKY TRADING

Trading was tricky in the second quarter. The euro collapsed versus the dollar and the yen. Risk premiums for U.S. corporate bonds, or the extra returns that investors demand for taking credit risk, jumped unexpectedly for both high-grade and junk debt.

Stocks dropped globally, triggering losses for some banks in U.S. equity derivatives.

This will be one of the most difficult trading quarters since the credit crisis, said Roger Freeman, an analyst with Barclays Capital. This quarter is a stark reminder that we have some major macro unanswered questions, be it the stability of the U.S. and the global economic recovery.

Among other unanswered questions are the impact of financial reform. Investors will watch carefully for signs of how new U.S. laws will influence banks' bottom lines.

Investment banking results, including low volumes of M&A and initial public offerings, could further weigh on results.

Global mergers and acquisitions are off to the worst start in six years. In the second quarter Goldman had $91 billion of announced transactions, down from $128 billion in the year-ago period. Morgan Stanley had announced $134 billion of M&A deals, down from $177 billion a year earlier.

Goldman and Morgan Stanley saw their proceeds from new issues jump dramatically in the second quarter from a year ago, but they were still significantly less than 2007 levels before the financial crisis.

For Morgan Stanley, the stakes are particularly high in the second quarter. The firm steered away from risk after the financial crisis, missing out on the windfall trading profits that bolstered Goldman's earnings early last year.

In late 2009, Morgan Stanley began taking more risk, hiring hundreds of salespeople and traders.

The volatility of the second quarter likely provided an early challenge for Morgan Stanley's revamped trading desks.

They have hired more bodies and presumably those bodies will generate more revenue for them, said Steve Stelmach, an analyst with FBR Capital Markets. The question is whether the environment going forward will lend itself to those new hires and how profitable will they be.

(Reporting by Steve Eder; Editing by Richard Chang)

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