Goldman, Now Entirely Behind The Curve, Hikes 10 Year Bond Yield Expectations To 3.75%
Goldman, which continues its near-revolutionary overhaul of its economic and market outlook, after suddenly and very embarrassingly hiking its economic outlook ahead of today's NFP number which confirmed that all those calling for an end to the recession were merely misled by the government (as Albert Edwards once again predicted spot on), was overdue for a change in its bond targets: after all there is no way the 10 Year can remain at 2.50% (the firm's old 10 Year target) if GDP is supposed to somehow grow to 2.7%. Sure enough, FUG (Franc Garzarelli, the man behind the firm's often very disappointing "Top Trade" recommendations) has just released the firm's new bond forecasts. And unfortunately, we get merely yet another indication that instead of being ahead of the curve, Goldman is now firmly behind it, and chasing either momentum or wrong conventional wisdom: the firm now sees the 10 Year going from its current 10 Year spot to 3.75% by the end of 2011, based on an "environment of strong growth, low inflation and a bond-friendly policy set-up." In other words: everyone pile into the reflation trade. We can't wait for two things: i) Rosenberg's retort, and ii) the over/under on how long before this latest flawed recommendation by Goldman is not only revised, but once again starts calling for a few trillion in QE (which just a month ago was supposed to be an addition $4 trillion - how quickly views change after a brief "closed door" meeting).
Below is Goldman new bond wish list:
Here is how Goldman is losing credibility one day at a time: below are their key views:
• Benchmark yields edge higher, led by firmer growth data and better risk sentiment.
• EMU periphery spreads still too high relative to their credit fundamentals.
• But will likely remain volatile in the coming weeks, as liquidity dwindles.
• Earlier this week we unveiled our updated global macro outlook, as well as our first Top Trades for 2011.
• We envisage an environment of strong growth, low inflation and a bond-friendly policy set-up.
• This backdrop implies strong tailwinds to risky assets, as reflected in our 2011 Top Trades.
• We see intermediate yields rising through 2011-2012, but not far above their forward paths.
The following constitutes the Global Macro & Markets Team’s current rate strategy recommendations, together with an update of our valuation models:
1. This week started with a broad ‘risk-off’ price action in global markets as tensions in the EMU periphery continued to escalate. But from Tuesday onwards, the market saw a complete turnaround, propelled by a strand of strong data globally, as well as short covering following suggestions that the ECB would intervene in the peripheral EMU bond markets more heavily. Intermediate government bonds in the main blocs have seen a significant sell-off during this week, particularly US Treasuries, which have briefly broken above 3.0% today, before falling back a tad following the Nonfarm Payrolls data today. Gilts have also underperformed on the back of strong data and rising inflation expectations.
2. Spreads on Italian and Spanish bonds—two systemically relevant EMU markets—have seen a significant compression since the local highs in November. We have long argued that the tensions on these two issuers were unjustified on the basis of their own credit fundamentals. The relief has come in anticipation of, and partly as a reaction to, yesterday’s ECB policy announcements. In particular, ECB President Trichet reminded investors that the Central Bank’s asset purchase program is alive and kicking. The ECB owns around 17% of the combined debt stock of these two countries. An extension of the purchases to Spain, or Italy, would entail much deeper involvement in the sovereign markets, and could be criticised for the credit distortions it could introduce.
3. The ECB also relaxed its refinancing policy, announcing there will be three more full-allotment 3-month LTROs in Q1. 2-yr Italian and Spanish bonds have an annualized basis point volatility of 150bp, two-three times the average of the past couple of years. An impairment of government bonds—particularly those of the bigger countries—represents a shift in the demand for liquidity, which an extension of term funding can only partially make up for. Overall, EMU spreads continue to trade too wide relative to their respective credit fundamentals , and while we think spreads should ultimately tighten, the environment will probably remain volatile in the coming weeks, as liquidity dwindles. In terms of primary markets, Italy issues (probably 5-yr, 15-yr, and 30-yr) are scheduled for December 14, while Spain is scheduled to issue (10-yr and 15-yr) on December 16.
4. Earlier this week we unveiled our 2011-2012 outlook for the global economy. We expect above-trend global growth of 4.7% over the coming two years—well above the consensus of 4.1%. We think most of the growth momentum will come from the US, and we have pencilled in a sequential acceleration of US growth to an above-trend 4% pace by early/mid-2012. Yet, despite our relative optimism on global GDP, we are looking for a moderate inflation dynamic in the advanced world, as there remains significant spare capacity. This macro backdrop maps to flat Fed funds throughout the next two years, a first ECB and BoE hike only towards the end of next year, and generally faster policy normalisation in the rest of the G-10 periphery and in emerging markets. We think this benign growth-inflation-policy mix should underpin risky assets globally, and indeed our five Top Trades for next year reflect various expressions of this theme through equities, commodities and high yield.
5. After being bullish on the direction of government bond yields for the past 18 months, in October we first signalled that the cyclical trough for longer-dated yields was upon us (we forecast 10-yr Treasury at 2.5% for the previous quarter). Going forward, we now see 10-yr yields in the major markets modestly rising, led by real rates. This entails bonds being in a ‘bear market’ over the forecast horizon, but one which should not pull the rug from under a pro-cyclical stance, as inflation and central banks remain friendly. We forecast 10-yr US Treasuries and German Bunds at 3.25% by end-2011, and JGBs trading at 1.5%. We have pencilled in a further 50bp sell-off across the major three markets in 2012. These forecasts are consistent with our forward-looking ‘fair value’ paths implied by our Bond Sudoku valuation model. More specifically, plugging in our macro and policy projections over the next two years implies a gradual pick-up in equilibrium yields from 2.75%-3.00% currently to the 3.50%-3.75% range for US Treasuries and German Bunds, and around 4.0% for 10-yr Gilts.
6. To be sure, any change in longer-dated inflation expectations resulting from abundant liquidity could take longer-dated nominal yields higher, and eventually force central banks also to react. One of the best risk-reward expressions of this possibility, in our opinion, is being long 5-yr EUR inflation—a trade we already recommend on a tactical basis against its GBP counterpart. The table on the front page summarises our 10-yr bond forecasts in major markets and a more detailed discussion on our forecasts will be presented in our December Fixed Income Monthly.
7. After this highly exciting week, the calendar next week looks quite light. In the US, we get the preliminary US Michigan consumer confidence for December, along with the November trade balance. The weekly jobless claims data have become very important of late in light of some evidence that the outlook for the jobs market is gradually brightening. In Euroland we will have most of the hard industrial data for October, as well as the final PMI readings. On the policy front, the Bank of England meeting will be the main event next week.
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