Goldman: The bond sell-off will continue

There are three key reasons why the bond sell-off will continue, according to Goldman Sachs’ analyst Francesco Garzarelli.

The bond sell-off, which started at the end of last week and has continued into this week, sparked panic in global markets. The sell-off spread to high yield equities, which have become bond proxies as yields have plummeted to record low levels.

The bond sell-off will continue

Goldman Sachs has some of the most bearish views on Wall Street about bond yields. The bank expects the US 10-year Treasury yield to reach 2% by the beginning of 2017, 25 to 35 bps above the forwards over this horizon. The corresponding numbers for German yields and JGBs are 0.3% and 0.1%, respectively – both above the forwards.

These views run contrary to the outlooks of many other analysts on Wall Street, and only time will tell if Goldman is on the right track. Analysts across Wall Street have consistently issued overoptimistic bond forecasts since 2008, and there is no reason to believe that, this time, the predictions will be any more accurate.

The bond sell-off will continue
The bond sell-off will continue

Here are the three “considerations” that make up Goldman’s case for an extension of the repricing of bonds:

1. Bond valuations are still stretched

“The deterioration in rolling year-ahead macroeconomic expectations has not been enough to justify the sharp drop in bond yields seen post ‘Brexit’… we expect economic activity in the advanced economies to expand at around trend levels, headline CPI inflation to receive a boost from base effects in energy prices, and the Fed to raise policy rates – an outcome we believe the market under-prices even for the remainder of this year.”

2. The influence of QE on the term premium is reversing

“Our empirical research shows that a sharp decline in the term premium across all major bond markets (and the associated fall in long-run break-even inflation) can be for a good part related to the large-scale purchases of bonds by central banks in Japan and Europe, particularly at the very long-end of the yield curve… Both the BoJ and the ECB have now put their QE operations under review in order to assess how to improve the transmission of expansionary monetary policy… Our baseline case is that low/negative rate policies and QE will continue into 2017 in Japan, the Euro area and the UK as inflation remains below target. That said, shifts between real short-term rates and the quantity of money as a policy instrument, as well as in the distribution of the deterministic central bank purchases along the term structure, can have material effects on how the yield curve is priced.”

3. A bigger role for fiscal policy is creeping into expectations

“Expectations that Treasuries will adopt more reflationary policies have increased since the summer…The market appears increasingly responsive to such moves, as it considers them more effective in supporting final domestic demand when interest rates are close to their effective lower nominal bound.”