Unlike most of its competitors, Bank of America is not shy to admit when it has made a major forecast mistake due to being, as it puts it, "overly optimistic", and that's precisely what the bank's rates strategist did earlier today when in a note titled appropriately "marking to misery", BofA's Ralf Preuser said that "our old forecasts imply an unrealistically optimistic backdrop for remainder of 2019, we cut our forecasts across the board." The reason for the revision: "Trade, central banks, inflation & Brexit have surprised", in other words pretty much everything that the bank had expected just a few months ago... was wrong.
Here is Preusser's explanation of how everything that could go wrong went wrong:
When the facts change, we change our opinion
We started the year with a bullish bias in our yield forecasts vs consensus and our economists. Following the latest tariff developments, our yield forecasts imply a best case scenario for a resolution of the US-China trade dispute, which seems unrealistic. We cut our forecasts across the board.
Trade wars, central banks and inflation have all surprised
It would be simplistic to blame these forecast revisions purely on the latest chapter in the trade war saga. Central banks globally have shifted to a dramatically more dovish tone. And inflation has continued to disappoint - surprisingly so in the US, and sufficiently in the Euro Area (EA) to finally appear on the ECB's radar screen. Finally, Brexit and related uncertainty remains unresolved.
And speaking of central banks throwing in the towel...
Central banks' reaction functions around the globe have changed materially. The Fed has abandoned both the hiking cycle and balance sheet run-off. The ECB has kicked off a debate about tiering. The RBNZ has cut rates, the RBA is expected to ease in June. And most other central banks have followed suit, with dovish tones from the likes of the BoC and the Riksbank.
The reasons behind the decision to change tack are myriad. Initially, the tightening of financial conditions on the back of the 4Q18 financial market turbulence was a major factor. The sharp revisions to inflation expectations are a more recent concern. For some central banks more idiosyncratic issues are at play: disappointing growth and housing market woes in Australia, evolving views on the impact of Brexit induced uncertainty for the BoE, and the fears of currency appreciation on being out-doved by the Fed for many.
Almost as if central banks know something the rest of us don't.... Or perhaps those 99 lead balloons that Michael Every warned about earlier, are indeed about to start falling.
So now that all hell is about to break loose, what does that mean for yields... besides lower "across the board" of course? Here is MS' explanation:
US 10y yields to 2.60% at year-end
Our new forecasts continue to express a slightly more cautious balance of risks relative to our economists' modal forecast. Crucially, however, we remain above forwards even then. We continue to favor real and nominal curve steepeners, as well as 30y breakeven longs as soft duration shorts.
We cut our forecasts in US 10y to 2.60% from 3.00% for year-end. This reflects a slightly negative bias relative to our economists' modal forecast, but still leaves us expressing a small bearish bias versus the forwards. We see curves steeper, breakevens wider and the US underperforming on a cross market basis, as duration longs remain crowded and front-end pricing is approaching extremes outside of 2007
Bund yields at risk of new lows of -25 bp in Q3
The EA remains asymmetrically exposed to global event risks, as well as facing potentially serious headwinds from oil and FX. There is room for the market to reprice the ECB further and for term premia to turn more negative given increased periphery vulnerabilities.
In EUR rates, we revise our forecasts for Bunds to -10 bp from 30 bp for year end. This partly reflects the change in ECB view from our economists. Crucially, we see Bund yields at risk of reaching new lows of -25 bp in Q3 as we approach crunch time on accumulated event risks. The structural underweight in EUR rates vs the US as well as the asymmetry of macro risks creates the room for Bunds to outperform. This motivates our constructive stance relative to forwards over the forecast horizon. We favour real rate curve flatteners and see the belly outperform the wings vs forwards across flies.
Gilts: a low quality duration trade
We have revised our rate profile lower. As Brexit drags on and the list of global risks lengthens, we see the BoE struggling to raise Bank rate over the next 12 months. This limits the upside to rates in our view. Our new forecasts remain marginally bearish relative to the pessimism priced in to the forwards.
Given the increased chance of the UK facing persistent uncertainty, both domestically and globally, our economists have cut their growth forecasts for 2020 by 50bp to 1.1%. 2019 has been revised up marginally after the strong Q1 print. They have also pushed out their forecast for the next BoE rate hike to May 2020. We argued after the last BoE meeting that even if a Brexit resolution is found, the BoE would find it hard to hike rates meaningfully given the global backdrop, which have now been priced out entirely from the front end.
We have revised our rate profile lower off the back of our economists change in forecast and in line with our US and European colleagues. As Brexit drags on and the list of global risks lengthens, we see the BoE struggling to raise Bank rate over the next 12 months. This limits the upside to rates in our view. Our new forecasts remain marginally bearish relative to the pessimism priced in to the forwards.
Going back to the US, BofA cautions that there is a likelihood of an even lower bone yield as the "key near-term risk to our rates forecast is a significant deterioration of US-China trade negotiations, though we currently believe a full blown trade war is unlikely." Alas, it now appears that a full-blown trade war - at least until the market crashes and forces Trump to the negotiating table - is now the base case. Additionally, "there is also uncertainty and downside risk surrounding the global growth outlook and political landscape in the US. A resolution of trade tensions and a resilient US domestic economy, on the other hand, would challenge front-end pricing."
And now that BofA has thrown in the towel, expect the rest of Wall Street to do the same, admitting they too got absolutely everything wrong on the bond side. The only real question is when will stocks follow yields which are going much, much lower.