Goldman Warns Bond Traders Not to Bet Against Policy Divergence

Mind the Gap: Are We Seeing Signs of Policy Divergence?
  • Bank forecasts three Fed interest-rate increases this year
  • Analysts expect 2016 policy gap in line with 30-year average

Policy divergence between the Federal Reserve and other central banks may continue longer than bond traders expect, say analysts from Goldman Sachs Group Inc.

The analysts say investors view policy divergence as unsustainable -- yet Goldman hasn’t found much historical support for that opinion. If the Fed raises rates three times this year like Goldman expects, “it would not imply a gap between U.S. and foreign rates that is unusual or implausible by historical standards,” analysts led by Jan Hatzius wrote in a March 8 note.

That means the gap between yields on short-term debt in the U.S. and other developed economies may grow. The difference between two-year U.S. and Japanese yields widened on Tuesday to the largest since 2008, while the gap between U.S. and German two-year yields reached the most since 2006 the day before.

QuickTake Fed Liftoff

If the Fed continues on the pace the analysts expect, the divergence will be about average among post-1985 policy gaps by the end of this year, according to Goldman, rising to the 76th percentile by the end of 2017 and the 86th at the end of 2018. The European Central Bank is forecast to cut rates further below zero on Thursday.

Market Losses

Treasuries fell Wednesday on the heels of government-debt declines in Japan and Europe as derivatives traders boosted bets on a Fed increase this year.

Benchmark 10-year yields rose five basis points, or 0.05 percentage point, to 1.88 percent as of 5 p.m. New York time, according to Bloomberg Bond Trader data. The 1.625 percent note due February 2026 fell 14/32, or $4.38 per $1,000 face amount, to 97 24/32. The yield dropped eight basis points Tuesday, the steepest decline since Feb. 18.

Futures prices imply a 73 percent chance of a Fed rate increase by the end of this year, up from 68 percent Tuesday.

Goldman, one of 22 primary dealers that trade with the Fed, projects the central bank’s rate path will lift the 10-year Treasury yield to 2.75 percent by year-end. That would imply a 6.9 percent loss for the 10-year security maturing in February 2026, according to data compiled by Bloomberg.

The U.S. sold $20 billion of the 10-year securities at a yield of 1.895 percent Wednesday. The bid-to-cover ratio, a gauge of demand, fell to 2.49, the lowest since August, from 2.56 at last month’s sale. It was the second of three note and bond auctions this week totaling $56 billion.

Traders are still betting on a much slower path of rate increases than the projections from Goldman and the Fed, according to futures prices compiled by Bloomberg. The year-end implied rate of 0.63 percent is well below the 1.375 percent rate projected by Fed officials at their December policy-setting meeting.

Some of that can be tied to the view that negative rates have a stronger effect on exchange rates than other types of easing, according to the analysts. That would mean negative rates abroad would lead to a stronger dollar, which could suppress inflation and growth and put the brakes on rate hikes. 

Last month, the trade-weighted dollar had the strongest negative correlation in more than two years with the 10-year break-even inflation rate, or gap between yields on Treasuries and equivalent inflation-indexed securities.

Additional Fed tightening could lead to more strength in the dollar, the Goldman analysts said.

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