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Goldman Raises Q1 10 Year Forecast From 3.25% to 3.50%

Tyler Durden's picture


Goldman's Francesco Garzarelli throws some numbers at its Bond Sudoku model, spins around its Wavefront Growth equity basket, and the magic firm's 8-ball spits out the following: "we presently show a 3.25% level in US 10-yr rates at the end of Q1:11. In light of the strength of the data, this now looks too low, and we would now lift the forecast to 3.5%. Our end-2011 and end-2012 projections are 3.8% and 4.3%, respectively, and we stick to these." In other words, if the market moves, we will adjust our "forecasts" accordingly. If China hike 3 more times as is expected and the 10 Year falls off a cliff, well then, we will no longer "stick to those."

From Goldman Sachs' Francesco Garzarelli

US Rates: Where Next?

The strong ISM and payroll reports last week have led to a sharp sell-off in US rates. 10-yr Treasury yields, currently at 3.63%, have broken above the 2.30-2.50% range they had been trading in since the middle part of December. In the process, the US yield curve (measured as difference between 2- and 10-yr maturity rates), has steepened, confounding the flattening priced into the forwards.  We have been arguing since last November that the trajectory for rates was pointing upwards, and have recently played the market from the short side in Euroland. But the speed of adjustment in US fixed income continues to be faster than what we envisaged. Where does all this leave us?

Starting with valuations, our Bond Sudoku model (which takes into account macro expectations in the US and overseas at a 1-yr horizon) indicates that 10-yr US rates are now around 1 standard deviation ‘cheap’ relative to ‘fair value’ (3.3%). This statement presupposes that the macro outlook is stable, which is probably too strong an assumption. Our US team, for example, has shaved 25bp from their unemployment rate forecasts after last Friday’s numbers and has signaled some upside risks to core inflation. Similarly, the US Wavefront Growth equity basket, which helps us infer changes in growth expectations priced in the S&P500, indicates that an extra 9bp have been added to US real GDP growth over the past week alone.

These considerations pertain to changes in the output gap, which now appears to be closing somewhat faster than previously assumed. If this were a ‘normal’ economic upswing, it would probably be all that matters. But the financial recession of 2007-09 has opened up a lot of slack in the advanced economies and left an overhang of debt. As Fed Chairman Bernanke reminded us last week, the level of the unemployment rate (9%, well above the 5.5% ‘official’ estimate of NAIRU) and that of core inflation (60bp, the lowest since the 1960s) both remain very far from the central bank’s medium term objectives of full employment and price stability. Indeed the longer-term risk to asset prices is not the modest upward drift in rates in response to better growth news, but would arguably be if key macroeconomic variables were not to show signs of mean-reversion after all the policy stimulus has been delivered.

To emphasize this point, and illustrate the implications for yields, in last October’s issue of our Fixed Income Monthly we ran “Taylor rule’ type regressions (which link yields to the unemployment gap and the distance between core inflation and the central bank’s target) for US policy rates and for different maturities along the term structure. Repeating that exercise today, we find that ‘optimal’ yields from overnight to the 3-yr maturity should still be negative, 5-yr notes should trade around 1.5% and 10-yr and 30-yr yields trade around 3% and 4%, respectively. Admittedly the standard deviations around these estimates are very large (in the region of 100bp), but the market has now factored in a fair amount of ‘cushion’.

Based on these considerations, the ‘bond debate’ can be currently couched in terms of a trade-off between the level and changes of the output gap. The former indicates that the front-end should remain well-anchored until sufficient slack has been removed, while the latter will signal how fast the adjustment is taking place.  For now, our conclusions are as follows:

Simplifying, one can think of expected government bond returns as determined by three macro factors: future growth, inflation and policy rates. Given the large amount of ‘slack’ in the US and other large advanced economies, we are of the view that underlying inflationary pressures and policy rates will remain dormant at least the next 6-9-months, even accounting for the pressures on commodity markets. The Fed’s asset purchase program is providing an additional ‘anchor’ to the yield curve in the 3-5-yr sector.

The dominant driver for (real) bond yields in the next couple of quarters will be the interplay between growth expectations and their realizations (in an upward trend). In this respect it is noteworthy that, since last October, the 2-10 slope of the US yield curve has tracked closely the US Growth Wavefront equity basket. It is also important to note that two-thirds of the re-pricing of bond yields since the ISM report has taken place from the real term structure. We calculate that 5-yr real rates, 5-yr forward (using the swaps market) are now hovering at 2%, where they stood in 2004-05 (readers who have attended our strategy conferences in Europe may recall that the title of our presentation on fixed income is ‘It’s for Real’).

If what we said in the previous point holds, it’s too early to think that bonds will pull the rug from under the equity market’s rally. Particularly since the level of bond yields across the US curve is still not restrictive (both our valuation model, and the ad hoc Taylor rule exercise mentioned above indicate that rates are at the upper end of a normal ‘valuation range’). On our baseline case, bond and equity return correlations will be low or negative – bonds selling off when stocks rally, and vice versa. What would start taking the shine off the stock markets would be an extension of the sell-off to the 4.0-4.25% area, especially if quick or not supported by a corresponding upward revision of macro expectations. This could be triggered, for example, by an unwarranted rise in longer-dated inflation expectations, which would hurt bonds and equities alike. We do not expect this and the data doesn’t suggest its coming, but we are definitely watching the Michigan survey data and inflation breakevens closely.

Turning to our forecasts and trades, we presently show a 3.25% level in US 10-yr rates at the end of Q1:11. In light of the strength of the data, this now looks too low, and we would now lift the forecast to 3.5%. Our end-2011 and end-2012 projections are 3.8% and 4.3%, respectively, and we stick to these. We will continue to look for opportunities to trade global fixed income from the short side, when opportunities arise. These will most likely continue to occur outside the US. For those readers looking for macro ‘hedges’ to an upbeat outlook for pro-cyclical assets in the advanced economies, we contend that intermediate maturity government yields fit the bill.

Where rates are still unreasonably expansionary is in large parts of the so-called growth markets, particularly Eastern Europe and Asia. Here forward rates do not sufficiently discount the inflation potential in these economies, where the output gap has closed, and credit growth is too brisk. In EMEA space, Poland and Turkey stand out. In Asia, as Fiona Lake has argued in her inaugural issue of the Asian Interest Rate Monthly, inflation risks are most pronounced in China, India, Indonesia and Korea, leaving the rates markets in these countries most vulnerable. While higher US rates would impact most markets in the region, Hong Kong and Singapore are most directly exposed to a rapid sell off in US rates


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Tue, 02/08/2011 - 08:25 | Link to Comment Sudden Debt
Sudden Debt's picture

Looking at real inflation, it's actually pretty VERY low. Inflation adjusted, it's NEGATIVE!


Tue, 02/08/2011 - 09:11 | Link to Comment More Critical T...
More Critical Thinking Wanted's picture


You only need to read the first line of the report:

The strong ISM and payroll reports last week have led to a sharp sell-off in US rates.

Reading that sentence wasn't particularly hard, was it? :-)

Also, lets put a perpetual ZH conspiracy to rest: the price of the 10Y bond went down despite the Fed buying long-term bonds for hundreds of billions of dollars through the QE2 easing effort.

Given core CPI dynamics the 10Y does not reflect hyperinflation nor stagflation expectations - it reflects growth expectations, which you can see by considering other observations as well:

  • the 10Y yield generally went down when food prices went up
  • the 10Y yield went up when there were good GDP growth numbers
  • the 10Y yield went up when there were good job market growth numbers
  • the 10Y yield went down on bad GDP numbers
  • the 10Y yield went down on bad CPI readings
  • the 10Y yield went down on poor job market numbers

Combine all those facts [*] and you will have to agree that 10Y yield expectations going up in the 10 years time horizon is pretty good news as far as the economic recovery expectations go ...

If you bet on dollar hyperinflation, if you bought gold at the top a month ago then it's still not too late to modify your bet :-)

Looking at real inflation

Prices go up and down all the time:

What matters to the question whether the US enters Japanese-style deflation is the 'core' bit (which metric is of course meaningless to the average citizen), the red line in the graph.

If that red line dips below zero it's very bad news - that's why economists (and the Fed) is watching that red 'core CPI' line so much.

If the blue line fluctuates around a lot that's of course painful when you have to buy the groceries but not nearly as much of a problem in terms of a future cemented-in deflationary trap.

[*] I realize that combining several facts and applying logic on them is not the strongest trait of libertarian/right-wing readers here, but I'm always hopeful that eventually one of them will manage it!


Tue, 02/08/2011 - 09:41 | Link to Comment c-rev with a twist
c-rev with a twist's picture

I don't disagree with your conclusions, but the bit about 'despite the Fed buying long term bonds' is a mistake many are making.  If anything, the Fed has largely been absent from long term treasury auctions.  Go check out the POMO schedule and show me where they're buying 30-year notes.  They're not.  They've also been pretty light on the 10-year relative to the shorter maturities.

Tue, 02/08/2011 - 12:03 | Link to Comment More Critical T...
More Critical Thinking Wanted's picture


Yeah, you are perfectly right there (and my sentence is incorrect), the Fed is shooting for the 3-5 year maturities, with some token 10Y/30Y flow, to keep a natural exit strategy open in form of letting most of the government bond balance sheet mature in a couple of years.

That way the mess of a reverse POMO can be avoided. [*]

I made that "bend the yield curve" argument before:

Assuming you generally agree with my (rather complex) points in that post (you might not) you first have to accept the notion that the Fed actually knows what it wants and that it has implemented a mechanism to go for that goal.

Which flies in the face of the irrational, anti-Fed belief of many commenters here.

[*] Sell-side POMOs are a political risk for the Fed: if they actually sell those bonds then real P&L calculations can be made and the Fed has to explain the losses ... If on the other hand they let these bonds mature then all the positions will be sterilized via principal+interest paybacks and at least nominally there will be no loss.


Tue, 02/08/2011 - 10:35 | Link to Comment Sudden Debt
Sudden Debt's picture

The fact you needed to include insults in your attempt to comment only proves how shortsighted you are.


But oké here I'll bother countering you BS:

 pretty good news as far as the economic recovery expectations go

Economic activity isn't near 2007 levels, yet inflation is way higher because how otherwise could you explain this market?

Economic expectations according to you are leading? Trillions printed yearly have nothing to do with it?


Your a shortsighted *BLIEP*



Tue, 02/08/2011 - 12:13 | Link to Comment More Critical T...
More Critical Thinking Wanted's picture


Economic activity isn't near 2007 levels, yet inflation is way higher because how otherwise could you explain this market?

In my interpretation the 10Y yield largely represents future expected growth, not today's actual economic activity. (which isn't all that bad btw., if you've been following the GDP readings.)

And yes, I fully agree with you that by looking at just the standalone 10Y yield value you cannot possibly tell apart which of it is "expectation of stagflation" and which is "expectation of real growth".

Which is natural: it's a single number only, it has no dimensions or attributes.

To answer that question of disambiguation I can only point you to the various behavioral patterns of the yield curve around key economic announcements which I listed in my original posting - which sheds light on the intent and expectations of those market participants that traded in the 10Y.

If those patterns tell you 'stagflation' then go for it. If they tell you 'future productive growth' then go for that.

I stated my opinion that it's the latter - but the real proof will only be available in 10 years time and I don't pretend to be able to see the future ...


Tue, 02/08/2011 - 08:28 | Link to Comment hugovanderbubble
hugovanderbubble's picture


GS and JPM are part of the scam, just pumping Commodities to generate inflation meanwhile RealEstate Assets plunge (specially those MBS, any backedsec products...MUNICIPAL BONDS ARE ALL IN DEFAULT...ALL BIFLATION AGE is a reality...

Commodities are a super bubble, unsustainable in the short term for any economy.

This is the same like march 2007...

Prepare for the worst High Volatility Regime in decades, the big epic event is coming....and is called " THE BIG PAPA"

Tue, 02/08/2011 - 08:31 | Link to Comment Sudden Debt
Sudden Debt's picture

I don't think so.

Commodities are going up because of supply demand.

Don't forget for example that about a year ago, the miners fired thousands so supply went down.

And only a small increase in demand can cause big spikes in the price.

Also, inflation always starts with commodities going up. That part, no government can manipulate for long.


Tue, 02/08/2011 - 08:34 | Link to Comment ak_khanna
ak_khanna's picture

The I fully agree with you that the primary reason driving up commodity prices worldwide are speculators armed with cheap money provided by central bankers and super fast computers. This is causing a havoc in the lives of rest of the population and pushing them towards poverty as they can no longer afford the basic necessities of life.

Tue, 02/08/2011 - 08:31 | Link to Comment ak_khanna
ak_khanna's picture

Th­e too big to fail bunch of banksters have a lot of influence on the political class, the rule makers and the rule enforcers due to their enormous purchasing power. So irrespecti­­­­­­­­­­­­­­v­e of the position in the government­­­­­­­­­­­­­­, everyone works for their benefit.

The rest of the population is least of their concerns. The only activity they do is pacify the majority of the population using false statistics and promises of a better future so that they do not lynch them and their masters while they are robbing the taxpayers.


Tue, 02/08/2011 - 08:45 | Link to Comment hugovanderbubble
hugovanderbubble's picture

Commodities are driven by Hedge Funds not by Real be cautious with a big reversal next days...


1.The US government allows this kind of action in order to avoid a JAPANIZATION II CASE (of Zero-Quasi Zero Long Term Interests Rates for decades)...

2.Its hard to say this, but please just explain how both soft and hard commodities, energy rocks 60% with QE....., come on back to real just a way to earn some time, before a big crash comes...

THey need to have a collateral with all those printing dollars issued....-----------> Commodities------------->not Real have been done  during 2 decades worldwide...- The big problem is they dont know the implications for these world wide riots cos food shortages and megaraising prices without margins for retailers...

The future is grey and turning heavy dark cos IMF and WB allows this financial behaviour...

All we need is a financial system backed with gold/silver and other hard assets creating a currency basket linked to those products . So now , the war is focused on controlling those hard assets...the country with more collateral, the powerful one...

Tue, 02/08/2011 - 09:14 | Link to Comment A Man without Q...
A Man without Qualities's picture

"The strong ISM and payroll reports last week..."

I love the way they kill any discussion about the payrolls report by merely stating repeatedly that they were strong.  It's classic modern message management.

Treasuries are falling because they're a crap investment.

Tue, 02/08/2011 - 09:21 | Link to Comment simon says
simon says's picture

Hey, that's Goldman's definition of "dynamic hedging".

Tue, 02/08/2011 - 10:39 | Link to Comment Bruce Krasting
Bruce Krasting's picture

It's Feb 8 we have seven weeks till the end of the Q. the ten year is at 3.67. Way above the Q end forecast of 3.5. So Goldy is saying that bonds actually will rally over the next month or so.

That's interesting. It would take new info of some kind to have this happen. The numbers that are in the pipe line over this period all llok "hot" to me and therefore a weker bond market would be in order.

I crisis someplace would get money moving back into bonds. We saw that for a day or so when Egypt was first blowing up. (Bonds now back on the lows) Is Goldie look for something?



Tue, 02/08/2011 - 12:13 | Link to Comment TruthInSunshine
TruthInSunshine's picture

Fading Goldman (their 'for public consumption' bullshit, at any rate; we are all too aware of their Abacus type scams) is literally the safest trade on the Street.

I'd love to see a historical compilation of performance of the 'fade Goldman' trade.

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