Goldman Sachs Explains The Twofold Impact on Markets From The Fed's Pragmatism

Tyler Durden's picture

Goldman's European strategist, Francesco Garzarelli explains how he interprets the market impact from the Fed's QE lite announcement: First "the Fed’s actions will act to push real rates out to 5-yrs deeper in
negative territory (currently -8bp). We forecast that nominal 5-yr
yields could reach 1%. Factoring in positive foreign macro influences,
and accounting for an already very depressed bond premium, we believe
10-yr government yields could rally to 2.5%, but are unlikely to break
below this level on a sustained basis." Second:" we remain of the view that the pro-active stance of policymaking, in the
US and overseas (see Monday’s note on China by Yu Song and Helen Qiao),
should continue to support moderate returns on risky assets, as cash
balances become increasingly expensive to hold, and cyclical volatility
declines." In other words, buy stocks. It's good to see the leopard never really does change its spots.

Overnight, the Fed announced that it will aim to keep its total holdings of securities (currently around US$ 2 trn) roughly constant by reinvesting principal payments on Agency debt and MBS (of which it owns US$ 1.3trn ) into Treasury securities. Bond purchases ‘will occur across the entire coupon and TIPS yield curves’ but they will concentrate primarily on maturities between 2- and 10-yr. At 3pm NY time today, the NY Fed will announce the first tentative schedule of operations through mid September. Actual purchases will begin early next week.

Our US colleagues have commented on the Fed actions in their latest US Daily. From a market perspective, we see the relevance of this announcement as twofold.

Firstly, on a rough estimate (there are many imponderables in the calculation, including the level of yields and pre-payments – the lower yields go, potentially the larger the purchases, and vice versa), Treasury purchases will amount to around US$ 15bn per month for as long as the program is kept alive. Considering that this compares to gross issuance of Bonds and Notes (incl. linkers) of around US$ 150-175bn, and net issuance of around US$ 100-125bn, the direct influence on bond yields will likely be modest. To put these numbers in context, last year the Fed was buying US$ 40bn of Treasuries per month, in addition to GSE securities, admittedly amidst more widespread fears of ‘excessive supply’ than today.

Nevertheless, the policy reinforces the commitment to keep policy rates on hold by keeping excess liquidity in the money markets. Interestingly, the price action yesterday showed real rates rallying, and inflation breakevens widening. As we have said in our commentary, the Fed’s actions will act to push real rates out to 5-yrs deeper in negative territory (currently -8bp). We forecast that nominal 5-yr yields could reach 1%. Factoring in positive foreign macro influences, and accounting for an already very depressed bond premium, we believe 10-yr government yields could rally to 2.5%, but are unlikely to break below this level on a sustained basis. We do not see much room for breakeven inflation to fall, and we now think that 10-yr swap spreads will progressively widen to around 20bp by early next year, from around zero currently.

Secondly, the Fed has once again shown itself to be a pragmatic institution, ready to change course quickly in face of shifts in the macro economy. The expansion in final domestic demand and payrolls remains anaemic, and real GDP growth is losing the positive contribution from the fiscal stimulus. We think that these headwinds will continue to weigh on domestic cyclical stocks. Meanwhile, we would maintain a positive stance on corporate credit, reflecting the ongoing private sector de-leveraging, the decline in volatility and the broader search for yield. And, more broadly, we remain of the view that the pro-active stance of policymaking, in the US and overseas (see Monday’s note on China by Yu Song and Helen Qiao), should continue to support moderate returns on risky assets, as cash balances become increasingly expensive to hold, and cyclical volatility declines. Incidentally, we note that even on our new US forecasts, the deceleration to a lower trend should be over as we move into Q4.