James Caron, Head Of Interest Rate Strategy, Morgan Stanley

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JAMES CARON, HEAD OF INTEREST RATE STRATEGY, MORGAN STANLEY, TALKS ABOUT THE ECONOMY AT BLOOMBERG SURVEILLANCE

APRIL 29, 2011

SPEAKERS: TOM KEENE, BLOOMBERG SURVEILLANCE HOST

KEN PREWITT, BLOOMBERG SURVEILLANCE CO-HOST

JAMES CARON, HEAD OF INTEREST RATE STRATEGY, MORGAN STANLEY

9:07

TOM KEENE, BLOOMBERG SURVEILLANCE HOST: Jim Caron from Morgan Stanley, just had Byron Wien on. Jim, good morning.

JAMES CARON, HEAD OF INTEREST RATE STRATEGY, MORGAN STANLEY: Good morning.

KEENE: Just had Byron Wien on and he is talking like you are about a higher rate regime. You've been right. We've got inflation. We've got core inflation coming up, certainly the rate of change of core inflation gets your attention. When do we see that filter into the ten year yield?

CARON: Well, I think right now what we have to start to see is the growth start to manifest. And the second quarter and the third quarter is where we expect to see the payback from a very, very disappointing and weak first quarter, first quarter growth coming in at about 1.8 percent. Most Street consensus had it coming in at around four percent, so definitely a big miss for the Street.

So what that means is that we've got to make it up in the following quarter. So while we do have a higher yield forecast - we are right on consensus with a four percent ten year yield forecast by the end of the year, I think there is a lot of risk around that call. And the risk is that we don't get the growth to manifest itself in the second quarter and the third quarter, in which case the market could start to downgrade its growth expectations and yields just might stay in a low range around these levels.

KEN PREWITT, BLOOMBERG SURVEILLANCE CO-HOST: Well, if the ten year goes to four percent by the end of the year, then what do we buy instead right now?

CARON: Well, I mean actually if the ten year note is just going to go to four percent, then what I would argue is that if yields were to start to tick a little bit higher that with the carry that you would get in the ten year note that that would be about your break even. So owning the ten year point on the curve on a slight backup would make sense to us. Currently right now in the front end, we don't expect there to be any fed rate hike any time soon.

When I look at the futures market, we don't see rate hikes until probably May or June of next year, so the front end actually starts to look reasonably attractive, especially if you believe still that rates in the back end can creep a little bit higher. I would rather be in the front end of the two year note and the three year point on the curve.

KEENE: Jim, you look at the swirl of data out there. My data check I go equities, bonds, currencies, commodities. How correlated are we right now?

You guys run fancy correlation exercise to see how in sequence the markets are. How correlated are we right now?

CARON: Well, we are becoming less correlated, which is actually somewhat of a good thing. In fact, if you look at the recent data over the past couple of days, we've seen - based on Bernanke's comments - interest rates have fallen and equities have risen. I mean, you know, look at the Russell. The Russell is the only index out there to make new highs post the crisis, which is very interesting to us.

So I would say that correlations, yields are starting to break down a little bit and at least show some stability, which is actually giving us a risk on signal. So in that sense, I think risky assets look like they could do pretty well based on the interest rate outlook.

KEENE: Where is the most attractive risky asset?

CARON: Well, you know, that is definitely hard to say. It depends on a personal risk -

KEENE: That's why we asked.

CARON: Yes, exactly. Well, what I think that we are supposed to be doing right now is (inaudible). So the areas that I like to carry right now would probably come in in the high yield sector, the investment grade corporate sector as well. I think those yields have a nice spread over treasuries. I think we are in a range of our market.

I think it is time to clip some coupons. I don't think that yields will run away higher. I also don't think that they are going to drop extraordinarily fast. So any place where you can get a bit of a juicy coupon, like in high yield or in investment grade, that that yield is above treasuries, I think that makes a lot of sense.

PREWITT: Of course, you can get 25 percent in Greece.

CARON: You could, yes. But that would be a lot of risk though.

PREWITT: For a two year, that is way too much risk?

CARON: Yes, I think so.

PREWITT: Well, if the fed doesn't reverse course for over a year, then how many rate hikes can we get by the European Central Bank and then what is the result?

CARON: Well, I would argue that the central bank in Europe is going to hike a 100 basis points total from start to end. But the real question is is it really tightening financial conditions in Europe.

Does a 100 basis points higher in rate really tighten financial conditions? Our models say that it doesn't. It says that financial conditions, even though rates have been moving higher, have tightened - small. It's been a small bit. But it really hasn't - it hasn't really derailed the equity markets or the other risky asset classes in Europe.

So perhaps the ECB is on the right track to regaining credibility, to taking back some accommodation. At the same time, it is also not hurting its equity market. So maybe that is a lesson that the fed could take a look at.

KEENE: What are you going to be writing about or thinking about this weekend? Such a swirl and back and forth on various predictions. What is the Jim Caron focus as we go to Monday morning?

CARON: Look, I think that the absolute focus has to be that starting on Monday, we start to get the first look at second quarter data. All the data that we've got so far in April has everything to do with the first quarter, which we know was weak.

KEENE: Right.

CARON: So we get ISM on Monday, and then obviously we get payrolls at the end of the week, which is the ultimate data point that we're going to look at.

The key point to focus on there is going to be the household survey. The household data has shown that jobs have been growing quite a bit and at a very fast clip, more so than the establishment survey and the non-farm payrolls. The market is going to need to see that household survey continue to add jobs. If it sees that it is starting to waiver, I think that could be a very negative sign for bonds. Bond yields could start to go lower.

The second thing I'm going to focus on is the second week of May, where we have retail sales, CPI, and PPI. So essentially this is going to be - the first two weeks of May is going to be the first real look at the second quarter.

Going back to what I said earlier, that the second quarter is going to be the time where we test the growth thesis for 2011, if we had a bad first quarter, we need to see strength in the second quarter. And the next two weeks, tells us that we're going to see those initial data points start to come in. The market is going to focus on it, and I think it is absolutely critical.

KEENE: Just a beautiful summary there. Thank you so much. Jim Caron, of course, fixed income at Morgan Stanley. Ken, that really sets up the next 14 days, and, as Jim said, the beginning of that data for the quarter we are in now.

9:13

***END OF TRANSCRIPT***

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