The last time Goldman Sachs urged clients to "sell", it was gold - and in the next quarter, they were the largest acquirer of the precious metal via ETFs. So when the muppet-murdering bank suggests this morning that, while "we have been caught in choppy action" there is a slow awakening of Treasury bears and recommends shifting from a neutral to short-duration position in bonds... one can't help but wonder just what the bank will do with all the bonds clients sell to them...
Via Goldman Sachs,
On balance, we expect stronger economic data, evidence that core inflation is stabilizing (albeit at low levels), and neutral policies by the main central banks. We are entering this period with a positive stance on stocks, an underperformance of intermediate maturity bonds in core markets, an increase in inflation break-evens, and a constructive view on credit and sovereign spreads.
A Slow Awakening for the Bond Bears
Our call to be ‘bearish’ on the direction of rates during the second quarter (see Springtime, Bond Bears Awaken, 31 March), from neutral previously, have been caught in a choppy price action.
Since the end of March, total returns on US, German and UK 5-to-7-year bonds have been marginally positive. This has reflected a combination of factors:
- Short-dates US$ rates have been on a roller-coaster ride. Weather distortions have made it difficult to judge the underlying pace of growth. Meanwhile, investors’ interpretation of the Fed’s ‘reaction function’ have shifted between Chairwoman Yellen’s press conference on 19 March and the release of the FOMC minutes on 09 April.
- Expectations of further ECB easing have been kept alive by a string of low inflation prints. The short-end of the EONIA curve has been volatile and, on average, re-priced higher reflecting a progressive decline in excess liquidity and, arguably, the impact of more stringent regulatory pressures. But the intermediate to long end yields have fallen, de-coupling from their US counterparts.
- The BoJ’s ongoing bond purchase program is contributing to keep long-dated nominal JPY yields very stable, amidst rising inflation expectations. Ten-year JGBs now trade at the same level of last November (around 60bp), with 10-yr breakeven inflation 40bp higher.
- International tensions surrounding developments in the Ukraine have increased capital inflows into the Euro area (with the EUR playing the role of the ‘new Yen’) and led to a further decline in rates in core countries.
But the Warmer Weather Should Boost Their Strength
We acknowledge the difficulty of holding short rate positions in the current environment of low policy yields and the several cross-currents listed above. Nonetheless, we strategically stick to the view that the market is too complacent in discounting negative real cash yields out to 2017-18 in the major economies, and low rate volatility over this entire time horizon. The different macro models we run converge in saying that the very front-end of the US, and the long-ends of Germany and Japan have departed from their fundamental underpinnings, and are vulnerable to an increase in the term premium. We are currently recommending short positions in 10-yr German Bunds and long positions in 10-year Japanese inflation. As we commented on Friday, we would see peripheral EMU spreads remaining resilient to an upward adjustment in core rates, if predicated on an improvement in the macro outlook.
In support of our thesis, we note the following:
- Stronger macro data ahead: While the debate on the amount of residual slack in the labor market in the US remains a heated one, leading indicators of economic activity point to a rebound from the soft patch in the first quarter. Meanwhile, core inflation appears to be forming a bottom, reflecting price pressures in services and rents. With the Fed no longer locked into macro threshold guidance, there should be more room for policy rate forwards to reflect the evolution of incoming macro data. Admittedly, the debate on whether the Fed will start lifting overnight rates through the Reverse Repo Facility already in mid-2015 (as the FOMC ‘dots’ suggest), or wait until a later date and then remove the accommodation more rapidly (which has been a long standing view of our US Economics team) remains open. In either case, but especially under the second scenario, yields at the 3-to-5-year maturity should continue to increase (and the yield curve become more ‘hump-shaped’) as and when the pace of the expansion accelerates.
- Accommodative overall financial conditions: Recent gyrations in stock markets do not contain enough macro information to challenge this assessment. Rather, they appear to relate mostly to a sequence of risk unwinds in areas where valuations had rapidly changed (examples, tech stocks, UK domestic plays, Euro area peripherals). Supporting this idea, for sectors that have gone down in price, others that have outperformed (those exposed to emerging markets, and the energy complex provide two examples) without a clear mapping to macro risk factors (as Aleks Timcenko wrote in a Daily dated 24 April).
- Less segmentation in the Euro area: There is evidence that the fragmentation across the Euro area is slowly declining. Falling TARGET 2 imbalances reflect this, as peripheral banks continue deleveraging and repaying the LTROs, and investors outside the Euro area purchase peripheral assets (see Dirk Schumacher’s note on the topic). On our measures, peripheral spreads now trade tighter than what can be justified by macro fundamentals and credit ratings alone. Finally, the ECB appears inclined to compensate for the contraction in bank balance sheets through direct support of the securitization market (see our note from February on the topic). Steps towards credit easing would be supportive for growth, and lead to an increase in inflation expectations from presently low levels.
So sell Goldman Sachs your bonds! now!