Treasuries Defy Goldman Call as Returns Beat German, U.K. Bonds

  • Investment bank sees Fed interest-rate increase in December
  • Futures market gives 32 percent odds of liftoff in 2015

Treasuries have outperformed German and U.K. government bonds in October, defying Goldman Sachs Group Inc., which stuck to its call that the U.S. bonds were expensive, saying investors underestimated the outlook for inflation.

If the course continues, this will be Treasuries’ first back-to-back monthly gain since January, according to Bloomberg World Bond Indexes. Despite the rally, Treasuries remained near their cheapest level in eight years, data compiled by Bloomberg showed, even as traders pared bets that the Federal Reserve will increase interest rates this year. Yields climbed Tuesday before Fed Bank of New York President William Dudley and Governor Jerome Powell speak at a conference.

“Uncertainty surrounding potential liftoff in December is very high, and I wouldn’t sell Treasuries at these levels,” said Jussi Hiljanen, head of fixed-income strategy at SEB AB in Stockholm. “The market is paring back probability of a rate hike this year, but I don’t think we can rule that out completely. It’s getting increasingly difficult to decipher what the Fed said these days.”

The probability that the Fed will raise interest rates by the end of this year was at 32 percent, about half the odds from before the Sept. 17 Federal Open Market Committee decision, according to futures data compiled by Bloomberg. The calculation is based on the assumption that the effective fed funds rate will average 0.375 percent after the first increase.

The FOMC cited tepid price pressures as it left policy unchanged in September, when the consumer-price index sank to an eight-month low of minus 0.2 percent, weighed down by plunging energy costs. A bond-market gauge of inflation expectations is sliding toward the least in six years.

“Bonds are discounting too little inflation,” Goldman Sachs analysts led by Francesco Garzarelli wrote in a research note dated Oct. 19. “The negative contribution from energy prices to headline inflation will reverse at the turn of the year while a positive -- and growing -- one from service prices will become more prominent.”

No Surprises

Goldman Sachs analysts including Garzarelli have been warning that Treasuries are too expensive since before Fed policy makers deferred a rate increase last month, when 10-year note yields were closer to 2.2 percent. They also predicted a December liftoff at the time. The 10-year note yielded 2.07 percent Tuesday in New York.

While Goldman Sachs maintained its call on the December rate increase, it doesn’t expect policy makers to surprise markets.

“The Fed leadership will provide some additional guidance between now and the December FOMC,” the analysts wrote. “The upward move in the term structure should occur over the next couple of months, rather than abruptly after the hike.”

The 10-year break-even rate -- the gap between yields of fixed-rate and inflation-indexed Treasuries -- was at 1.46 percentage point, approaching the six-year low of 1.38 percentage point reached on Sept. 29. The rate was as high as 1.94 percentage point in June.

Treasuries returned 0.2 percent this month through Monday, compared with 0.1 percent from German bonds, according to Bloomberg World Bond Indexes. U.K. gilts lost 0.9 percent during the same period.

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