Following the risk aversion rally in bonds over the past month, as a result of the increasingly jittery outlook on stocks, many dealers have had to realign their positioning in the rates arena. And while some who have an outright short exposure on the fixed income market such as Pimco attempt to downplay their bearishness for fears of how LPs will react, others like Goldman are becoming increasingly more vocal in their bearish bias to fixed income. In a note released overnight Goldman's Francesco Garzarelli repeats that the firm which does god's work continues to be negatively inclined toward the treasury prices, reiterating its 10 year forecast (3.50% and 3.75% for 10-yr USTs by end-June and end-December), although not due to structural considerations such as the US being technical insolvent if not practically so (for the time being the US is more than capable of paying its interest expense out of collected tax revenue) but due to the ongoing false impression that the economy is improving. In short, due to still strong (and soon to be revised lower) forecasts on US GDP, coupled with increasing inflation expectations, Goldman urges clients to be short here: "Consistently, we would treat a further decline in intermediate to
longer-dated yields as an opportunity to recommend short positions
again." So while in the long-run Goldman is likely correct, it is for the wrong reasons. The right one, naturally, continues to be the latent threat of fixed income rumblings manifesting themselves via the latent bond vigilantes finally moving away from Europe and shifting their attention to the insolvent US. With the Fed shifting away from its position of structural support in the fixed income market following June 30's end of QE2, the economy will once again be in uncharted territory especially with a record amount of bonds needing to find willing buyers over the next 12 months. On the other hand, with GS clients urged to sell bonds, that means that as usual Goldman is buying, so take the typical reverse psychology approach to any Goldman call with a grain of salt.
From Goldman Sachs, Capped Upside for Bonds
Fixed-income markets have extended the rally in place since mid-April, with US Treasury yields now setting fresh lows for the year. On the back of lower commodity prices, the term structure of inflation has lowered and steepened from the front-end, while real rates remain depressed. Year-to-date total returns on 7-10-yr US T-notes are now around 3.0%, outperforming the European markets and Japan. Australian bonds – our ‘top pick’ –have posted the highest period returns among the majors. Weaker-than-expected economic data, including wage growth, continue to support our relative preference for AUD fixed income.
We retain a bearish strategic bias on market direction, consistent with our expectation of a rebound to above-trend GDP growth in H2:11 and a further increase in core inflation. Our forecasts for USTs are 3.50% and 3.75% for 10-yr USTs by end-June and end-December (spot: 3.13%). The corresponding numbers for German Bunds are 3.30% and 3.50% (spot: 3.1%), and 1.3% and 1.6% for JGBs (spot: 1.1%). These forecasts are higher than the forwards particularly in Euroland and Japan.
Our tactical views are informed by the following considerations:
- Yields have mirrored the relative decline of cyclical stocks in place since March. Over this period, the relationship between our Wavefront US Growth equity basket (which pits cyclicals vs. defensives in the S&P500) and the 2-10-yr slope of the US curve has been relatively tight. If recent patterns continue to hold, the yield curve could flatten by another 20bp to catch-up to where cyclicals currently trade on a relative basis. This would put 5-yr UST yields in the ballpark of 1.50% and the 10-yr in a 2.8-3.0% range. As discussed in yesterday’s Daily, however, we consider the underperformance of cyclical sectors relative to the broader index as reflecting a marked slowing in equity market growth expectations, perhaps somewhat beyond what the data currently indicate. Our price targets for the S&P500 are 1375 by end June and 1500 at year-end although we are mindful that the route there could be more circuitous than hitherto. Consistently, we would treat a further decline in intermediate to longer-dated yields as an opportunity to recommend short positions again.
- As a cross check, our Bond Sudoku model — which links 10-yr government bond yields to 1-yr ahead expectations on GDP growth, CPI inflation and short rates in the main advanced economies — indicates that 10-yr Treasuries should currently trade at 3.3% and 10-yr Bunds at 3.15%. A breach of the yield levels alluded to earlier (i.e., 2.8% on TY10) would represent a more than 1 standard deviation departure from our measure of ‘fair value’. According to our analytics, the current term structure of rates in the major economies is stimulative. In the US, it appears consistent with negative nominal overnight rates.
- Admittedly, growth forecasts have been sequentially revised downwards from upbeat levels at the start of the year, particularly in the US. This has been among the main drivers behind the underperformance of cyclicals and steep decline Fed hike expectations over 2013-14. But at the same time, forecasts of core inflation are increasing. In the context of our modeling work for bond yields, recent shifts in these two macro factors (lower growth/higher inflation) broadly offset each other. Feeding the model with our baseline macro projections for this year and next, we find that 10-yr US Treasury and Germany Bund yields should end 2011 at around 3.5%, or above. This is at least 30bp higher than the current year-end forward rate.