Treasury yields to rise in 2011: Morgan Stanley

Richard Berner and David Greenlaw, two economists with Morgan Stanley, predict that U.S. Treasury yields will rise in 2011. Over the next 12 months, they think 10-year yields, currently around 3 percent, will rally to about 3.75 percent.

Treasury yields move inversely to prices, meaning that the selling of Treasuries by investors will drive up yields.

Berner and Greenlaw make their argument mainly on the expectation that the economy will improve.

They said current yields are inconsistent with even the modest improvement in the economy that [they] expect.

Berner and Greenlaw expect the annualized economic growth rate -- at 2.50 percent for third quarter 2010 -- to accelerate to 3.5 percent for fourth quarter 2010 and 3 percent for the year 2011.

In their opinion, such economic performance should lead to yields higher than just 3 percent.

Treasury yields tend to rise as the economy expands because of higher inflation expectations, investors' shifting preference for riskier assets, and increased loan demand.

Moreover, investors pushed down yields anticipating that the Federal Reserve will complete the $600 billion it allotted for the second round of quantitative easing (QE2), which is a program for the Fed to buy Treasuries in order to push down their yields and thus lower the borrowing costs for the broader economy.

However, domestic and global backlash against QE2 casts doubts over the Fed's resolve to complete it.

Domestically, some politicians are threatening to take away some of the Federal Reserve's power and independence. Internationally, countries are mounting a currency (and possibly trade) war.

Thus, if it becomes increasingly likely that the Fed will not be able to complete QE2, yields will subsequently rise.

Lastly, as the U.S. continues fiscal stimulus measures and if Congress cannot agree on a plan in the future to reduce medium-term government deficits, yields will rise due to the eroding confidence in the creditworthiness of U.S. public debt.

While Berner and Greenlaw cite many reasons for predicting rising Treasury yields next year, they do think yields will fall in the very near-term because of Treasury purchases under the QE2 program.

Email Hao Li at hao.li@ibtimes.com