How the bond market could get crazier by Colin Barr @FortuneMagazine December 15, 2010, 10:17 AM EDT E-mail Tweet Facebook Google Plus Linkedin Share icons If you think the bond market is going nuts now, just wait till next year. So say economists at Morgan Stanley. They raised their interest rate forecasts Tuesday, saying the tax deal moving through Congress should goose growth and raise demand for funds. They downplayed the widely bemoaned impact on the bloated federal budget, saying the recent surge in government bond yields isn’t a sign of acute concern over U.S. solvency. This again? But there is no free lunch, and in the bank’s view the tab to be paid on the stimulus deal could arrive as a disruptive shoving match over the fast approaching U.S. debt ceiling. If President Obama is to play Bill Clinton by tacking to the center with a big tax cut, who is to stop John Boehner from making like Newt Gingrich? “Adoption of the tax bill will likely lead to a slightly earlier-than-anticipated need to hike the debt ceiling,” Morgan Stanley economists David Greenlaw and Richard Berner write. “This appears to be setting up as a real political donnybrook that could trigger significant market disruptions.” That’s quite a comment because you’d swear looking at the bond market rout of the past six weeks that we are already seeing some. The yield on the 10-year Treasury hit 3.49% after the latest round of selling Tuesday afternoon, following some more downbeat comments from the Federal Reserve. That’s almost a full point above its level the day after the Fed announced the launch of its second round of bond buying, known as quantitative easing or QE2. That means those who bought at the post-QE2 yield lows have already surrendered two years’ worth of the anemic income stream these low-yielding bonds provide. But Greenlaw and Berner say the selloff is actually good news, in the sense that it points to expectations that economic growth will pick up in coming months. That’s important because it will be impossible for American consumers, let alone their overextended government, to get financially well without the economy gaining some momentum. The economists expect the yield on the 10-year Treasury to be 3.25% at year-end and 4% at the end of 2011, both of which are up a quarter point from their previous forecasts. A rising tide that may not lift all boats Though they admit their analysis is hardly airtight, Berner and Greenlaw point to rising real interest rates, rising stock prices, a stable dollar and low volatility as signs that their expansion story is indeed what’s behind the yield pickup. Evidence supporting our view includes this week’s 30bp rise in real rates since the package was announced, along with a further rally in risk assets and the dollar. While that is hardly conclusive evidence, the fact that risk premiums (such as the VIX) have drifted lower also supports that view. By contrast, they find little evidence for the widely espoused view that a rise in yields equals frightened U.S. creditors running for cover. If deteriorating creditworthiness was the main source of the back-up in yields, we suspect that the dollar and risk assets would be weaker and both risk premiums and sovereign CDS spreads would be higher. None of those has occurred. In our view, sovereign risk is unlikely to come into play any time soon, although at some point a lack of fiscal discipline could well move into the spotlight. Which brings us back to the Boehner as Gingrich scenario. Boehner has said, more or less, that he won’t shut down the government. But there is some evidence Gingrich never learned anything from his implosion in the 1995-96 government funding clash. By all accounts Boehner is a more level headed sort, but who’s to say the requisite chest-puffing and talk of budget-cutting “principles” won’t draw him in too? Greenlaw and Berner certainly aren’t betting against it. In their view, the march toward government funding fisticuffs doesn’t necessarily presume a massive bond selloff — indeed, early Treasury auction disruptions could actually raise prices by changing the supply-demand balance, Morgan Stanley notes — but it could put yet another ding in the United States’ already scratched up financial reputation. At present, the Treasury is about $500 billion below the current $14.3 trillion debt ceiling and, assuming the pending tax deal is enacted, we estimate that the limit will be hit in March. However, at that point the Treasury can unwind the Supplementary Financing Program (SFP) and use other accounting mechanisms that have been employed in the past in order to continue to operate normally until May or June. At that point, the Treasury will likely run out of options, and the threat of cancelled auctions, a federal government shutdown, and missed coupon payments will begin to loom large. In fact, a replay of the 1995-96 stand-off on the debt ceiling now seems like a high probability. What this recovery lacks in job creation it may well make up for in pointless drama.