Three months ago, Goldman's Francesco Garzarelli released a note to clients advising them to short the 5 Year as follows: "We recommend going short 5-yr US Treasuries at 1.936% for a potential target of 2.30% and a close below 1.80%." Naturally, our cynical outlook on life prompted us to say the following: "As usual, since that would mean Goldman is now accumulating 5 Year inventory, it appears we will soon have a rather dramatic duel between the two biggest Wall Street titans: PIMCO and Goldman, at least as pertains to their outlook on rates." Well, Goldman won so far (its clients not so much). Today, Goldman is telegraphing that it is starting to accumulate the next batch of 5 years, which makes sense considering the point on the curve experienced its 3rd worst 3-day decline ever as reported yesterday. To wit: "Ahead of key data for June, starting with the June ISM report this Friday, we recommend initiating short positions in 5-yr UST at the current level of 1.70%, for an initial target of 2.00%, and stops on a close below 1.40%." Round two of Goldman vs PIMCO is now on.
This is what Goldman said on Marcy 18, and this is what it said last night:
Over the past month, global bonds extended the rally in place since mid-April. In the total returns space, the top performers continued to be the more cyclically-sensitive economies (US, UK, Australia). The Eurozone aggregate portfolio lagged, as the rally in Germany (+0.9 on the month, using the EFFAS index) was more than offset by negative returns in Spain and Italy (-1.6% and -1.1%, respectively).
At least in part, the solid performance of fixed income can be attributed to an ongoing shift in macro factors. In the US, consensus real GDP growth over the next 12-months is now 2.8%, or 40bp lower than in February, prompting investors to push back the time of policy rate normalization. By contrast, the outlook for activity has been upgraded in Euroland. One-year projections of CPI inflation is much higher than at the start of the year, but are no longer increasing. Based on the current array of macro expectations, our measure of ‘fair value’ for 10-yr government bond yields in the main markets that we track has fallen by around 10bp in June (see page 7).
With regards to the market’s direction from here, we note the following.
- In spite of the marginal decline in ‘equilibrium’ intermediate yields, bond valuations remain unattractive. The US and Canada stand out in particular, trading close to one standard deviation too expensive, according to our Bond Sudoku model. Barring a more substantial downward revision to the macro outlook, which we do not see as imminent given the much more conservative activity forecast levels we have now reached, we remain of the view that US 10-yr yields will not be able to hold much below current levels.
- Regarding the macro outlook, the pace of economic recovery is admittedly lackluster. But expectations have now adjusted lower, and we may see some bounce in industrial indicators as supply-side disruptions stemming from the Japan earthquake fade. Evidence of this has already begun to transpire. Headline inflation is stabilizing because of favorable 'base effects' in the food and energy components, but ‘core’ inflation remains on an upward trajectory in most advanced economies.
- The ongoing European sovereign crisis has kept the allocation to government bonds heavily skewed to the highly rated countries. As discussed below, a gradual resolution of tensions surrounding Greece should lead to a broader distribution of risk, to the benefit of the larger, more liquid sovereigns of the Euro area.
Based on these considerations, we maintain our view that intermediate maturity yields will be around 50bp higher in the second half of the year, and some 30bp above the forwards. Our forecast total returns in 2H11 are -5% for US Treasuries and -3% for German Bunds. The combination of greater inflation pressures, and lower trend growth rate should translate into less convex yield curves between 2- and 10-yr maturities (with the 3- to 5-yr sector underperforming) and flatter term structures thereafter.
Ahead of key data for June, starting with the June ISM report this Friday, we recommend initiating short positions in 5-yr UST at the current level of 1.70%, for an initial target of 2.00%, and stops on a close below 1.40%.