Goldman Has Three Reasons Why the Bond Rout Is Going to Get Worse

Stretched bond valuations, waning impact from quantitative easing, and rising importance of fiscal policy. Oh my.

Monetary Policy Feeding the U.S. Corporate Bond Rush

Yields on 10-year U.S. Treasuries have been doing their best impression of a soaring eagle in recent days, following examples set by Japanese and German government debt.

The rout in global bonds, which has seen yields on the U.S. 10-year rise 15 basis points in two days as investors backed away from buying the debt, has coincided with a sell-off in other assets and prompted a flurry of comparisons to the 2013 "taper tantrum" that erupted as investors fretted over potentially rising U.S. interest rates.

The bond rout is only set to continue according to Francesco Garzarelli, London-based co-head of global macro and markets research at Goldman Sachs Group Inc, who cites three key reasons for higher U.S. Treasury yields to come. The bank is now predicting that yields on the 10-year note will reach 2 percent towards the beginning of 2017 — or about 32 basis points higher than the current yield level on the debt.

"The resultant drop in stock market indices may slow the move up in yields but not reverse it, in our view," Garzarelli said. "Importantly, we do not see a normalization of the bond premium from such low levels as detrimental for the economic recovery."

While Goldman has been forecasting higher U.S. yields for a while, their call stands in contrast to the analyst consensus prior to the recent tumult in bonds, which saw strategists' forecasts for where the 10-year Treasury yield will go sink to ever-new lows. Analysts had been converging with the forward market-implied for bond yields, effectively moving closer to pricing in secular stagnation — or the notion that economies will be marked by little or no growth for the foreseeable future.

On Sept. 8, Brean Capital LLC Head of Macro Strategy Peter Tchir noted that the spread between the forward and the estimated yield shrank to its lowest level on record, for instance, with the median forecast nosediving in July. "Capitulation?" he wondered. "The last time analysts let their forecasts chase yields down (in February) we saw a bump in yields (one of the only times all year)."

Here are Goldman's reasons why the bump-up in yields is set to turn into a punch higher.

1. Bond valuations have been stretched for a while now

The sharp drop in bond yields following the U.K. referendum to leave the European Union has not been justified by a slowdown in economic growth that would normally send investors scurrying into the relative safety of government debt, Garzarelli argues. With Goldman expecting economic activity to pick-up in developed markets, the crowding of investors into government bonds looks odd.

"Over coming quarters, 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[eral Reserve] to raise policy rates – an outcome we believe the market under-prices even for the remainder of this year," Garzarelli said.

On that basis, 10-year U.S. Treasuries should be trading closer to 2 to 2.25 percent.

2. Quantitative easing is losing influence

Bond purchase programs by central banks have helped compress yields on government debt but that effect may now be waning, Garzarelli argues, with growing realization of the technical restrictions and downsides to unconventional monetary policy now emerging. He cites the example of recent discussions by the Bank of Japan and the European Central Bank as to the limits of unconventional monetary policy.

"There are various reasons why such an assessment is necessary at this juncture. One of them is that the sharp fall in ultra-long dated yields has resulted in costs and distortions counterbalancing the economic benefits of lower real rates," he said. "Consider that pension and life insurance companies in Europe and Japan have large stocks of defined liabilities and asset allocations skewed towards fixed income products. When long-term rates decline, these financial institutions tend to manage down their risk exposure, rather than increase it."

3. Everyone's hoping for fiscal policy now

With ever-increasing questions over the willingness and ability of central banks to keep on 'QEasing', more investors are looking to government-led measures to help spur economic growth. Expectations of such fiscal measures have been rising in Europe and Japan, despite increasing budget deficits, as well as in the U.S., Garzarelli argues.

"In the U.S., discussions on the possibility of an easier fiscal policy are linked to the outcome of the Presidential election," he says. "But 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."

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