As of a few hours ago, Goldman's Francesco Garzarelli has officially told the firm's clients to go ahead and short 10 Year Treasurys via March 2012 futures, with a 126-00 target. While Garzarelli is hardly Stolper (and we will have more on the latest Stolpering out in a second), the fact that Goldman is now openly buying Treasurys two days ahead of this week's FOMC statement makes us wonder just how much of a rates positive statement will the Fed make on Wednesday at 2:15 pm. From Goldman: "Since the end of last August, we have argued that 10-yr US Treasury yields would not be able to sustain levels much below 2% in this cycle. Yields have traded in a tight range around an average 2% since September, including so far into 2012. We are now of the view that a break to the upside, to 2.25-2.50%, is likely and recommend going tactically short. Using Mar-12 futures contracts, which closed on Friday at 130-08, we would aim for a target of 126-00 and stops on a close above 132-00." As a reminder, don't do what Goldman says, do what it does, especially when one looks the firm's Top 6 trades for 2012, of which 5 are losing money, and 2 have been stopped out less than a month into the year.
What is Goldman's rationale for shorting 10 Years?
At this stage of the cycle, growth expectations are in the driver’s seat: The value of intermediate maturity government bonds can be related to expectations of future policy rates, activity growth and inflation, and a ‘risk factor’ highly correlated across the main countries. These simple relationships are captured by our Sudoku econometric framework for 10-yr maturity yields. In coming months, we expect effective overnight rates to remain close to zero in the main currency blocs (US, Japan, Euroland, and UK) and retail price inflation to hover around 1.5-2.0% – consistent with the forwards and central banks’ objectives. With policy rates and inflation ‘dormant’ at this stage of the business cycle, bond yields (and the 2-10-yr slope of the yield curve) will likely react mostly to shifts in growth expectations.
Bond valuations are already stretched relative to consensus growth expectations: Around the turn of the year, the outlook on economic activity was buffeted by cross-currents reflecting the adverse credit conditions in the Euro area on the one hand, and the upward revisions to US GDP growth on the other. Our Sudoku model, which helps us trade-off these shifts, indicates that 10-yr government bond yields are currently trading too low (to the tune of 50-75bp) when mapped against prevailing macro expectations. Taking into account the cumulative impact of the Fed’s security purchases, the degree of mis-valuation of 10-yr bonds is roughly the same across the main regions.
Bond yields are lagging the improvement in industrial activity seen since late 2011: The momentum of our Global Leading Indicator (GLI) for the industrial cycle bottomed out in the fourth quarter of 2011, although the revised series after the latest data show it steadily improving through the second half of last year. The sequential improvement has extended into this year. We observe that, since policy rates have been floored in early 2010, intermediate maturity yields have tended to lag improvements in the GLI by around 2-3 months. With central banks on hold providing ‘carry’, fixed income investors may have been wary to trade on early cyclical signals until these received validation in the early ‘hard’ data.
Real rates (and the 2-10 curve) could play catch-up with cyclical stocks: We have identified a relatively tight positive relationship between the relative performance of US cyclical stocks vs. defensives (as captured, for example, by our US Wavefront Growth equity basket), and the 2-10-yr slope of the Treasury curve. The departure from this relationship since the turn of the year is now eye-catching. Cyclical stocks have strongly outperformed the broader market, a move probably amplified by positioning, while bond yields have barely moved, underpinned by US domestic investors’ continued attraction for ‘carry’ strategies. At a closer inspection, yields out to the 5-yr maturity have continued to decline in real terms, and are now in deeply negative territory (-150bp in 2-yr and -100bp in 5-yr, near the early November lows), while 5-yr 5-yr forward rates are barely above zero. Our estimates suggest that forward rates (5-yr 5-yr forward) are now too low. Incidentally, the fact that a potential rise in yields would come from a depressed base and mostly in response to an improvement in growth prospects (which should also influence earnings growth expectations) means that a fixed income sell-off should not pose a threat to the equity market.
The FOMC statement could provide a near-term catalyst: According to a client survey by our US trading desk, around half of those polled expect the Fed announcement to ease financial conditions further, with only 12% expecting a tightening. Around two-thirds of participants believe the mid-point of the ‘central tendency’ range for the Fed funds rate at the end of 2014 will be 75bp (the forwards) or below. Finally, 72% of respondents expect the FOMC will announce a long-run neutral policy rate of less than 4%. These results are consistent with our impression that Wednesday’s announcement is now largely discounted to represent an ‘easing event’. With the data improving, treasury yields below ‘equilibrium’, current coupon 30-yr mortgage yields at all-time lows, and discussions on policy easing shifting to ways to support the improvement in the housing market more directly, such expectations may be disappointed, in our view.