Having been proven wrong for so many months (and years) in its optimistic outlook on the economy, one would think Goldman Sachs – who as we have repeatedly documented has been extremely bullish on the USD as a result of what it believes will be several rate hikes due to an economic recovery that just refuses to come – would take the summer off when it comes to predictions. No such luck, and in an overnight note, Goldman is once again trying to forecast what will happen to rates in the coming months.
According to Goldman’s Franceso Garzarelli (whose 5 out of 6 top trades for 2016 suffered a spectacular collapse early in the year), Goldman’s baseline case is for yields to climb higher, “possibly sharply, in the second half of the year.” One could say that Goldman is once again confusing what it wants to happen (an inflationary spike higher) with what will happen (ongoing global deflation as every central bank rushes into US paper sending yields to record lows). In any case, Goldman justifies its this view based on the following observations:
- The weak payroll report seems like an outlier when stacked against a broader set of jobs market indicators. Separately, the average of UK polls continues to give the ‘Remain’ camp an advantage over ‘Leave’. A lack of strong conviction and wrong-footed positioning has taken asset prices where they are, rather than a more negative reappraisal of the outlook.
- On our forecasts, higher realized price and wage inflation in the US will prompt the Fed to hike twice (currently there are 18bp cumulative hikes priced to December, and a very modest tightening pace beyond that date).
- We expect a stronger interaction between easier fiscal and monetary policy in the Euro area and Japan, contributing to raise inflation expectations from their very depressed levels currently (in both countries, forward inflation is priced to be below trailing core inflation, which is at odds with the forward term structure of crude prices).
- Bond valuations are again very stretched, with US 10-year Treasuries now approaching 2 standard deviations ‘expensive’ on our long-run metrics. Unless the macro outlook seriously deteriorates (which would challenge the low levels of asset volatility), we would expect a convergence of yields to levels that are consistent with their macro underpinnings (for the US, at least 2%).
US Treasuries are Now Approaching 2 Standard Deviations Expensive:
Sudoku Misvaluation of 10-year US Treasury
- In this context, consider also that a ‘neutral’ exposure implies greater duration risk. Indeed, as discussed in last Friday (see Global Markets Daily, Duration Exposure in US Fixed Income Markets at an All-time High, 3 June 2016), the duration of aggregate fixed income benchmark is the highest in decades (resulting in a combination of longer-dated issuance and lower discount factors). An increase in duration is also visible in the Euro area and Japan, on both government and corporate indices, although admittedly in both regions central banks are removing a considerable amount of that risk from private investors’ hands. In stocks, positioning in equity markets is skewed towards long Staples and short Financials – which would be challenged by an upward shock to rates.
On the surface, this would be merely another forecast that Goldman will almost certainly get wrong. In fact, one can say that – as has been the case countless times – Goldman is merely trying to get its clients on the opposite side of its own prop, pardon, flow trade.
But a question emerges: what happens if Goldman is right this time. Because what Garzarelli forgot to mention is that an “upward shock” to rates, one which would be comparable to the VaR shocks in JGBs in 2013 and in Bunds in 2015, would leat to staggering losses.
Recall what Goldman’s Charles Himmelberg warned about just last week, namely that the record amount of debt oustanding (and duration exposure) has never been greater, leading to potentially dramatic consequences:
“The total face value of all US bonds, including Treasuries, Federal agency debt, mortgages, corporates, municipals and ABS, is $40 trillion (Securities Industry and Financial Markets Association). The Barclays US aggregate is a smaller number, $17 trillion, as the index excludes some categories of debt, such as money markets, with low duration. To end up with a more palatable number, Goldman uses the Barclays measure of debt outstanding, although it admits this may lead to an understatement of the total loss potential. Using either measure, total debt outstanding has grown by over 60% in real Dollars since 2000.”
Then there is duration to worry about…
“The aggregate interest rate duration across the bond market has also increased over the past several years, up over 20% vs. the 1995-2005 average level. Longer durations are largely driven by lengthening maturities on the bonds outstanding, as issuers have elected to term out their debt structures. Exhibit 4 shows that the average maturity of corporate bonds issued in 2015 and 2016 is over 16 years, vs. an average of 8.6 years during 1995-2005. The US Treasury has also chosen to lengthen its debt maturity structure, with more use of long duration bonds…. In 1994, the average yield on the bond index was 5.6%, vs. 2.2% currently. Lower bond coupons means that proportionately more of the bond cashflows now comes from principal, which tends to be distributed towards the end of the bond lifetime.”
Doing the math, and combining a duration estimate of 5.6 years with the SIFMA total estimated notional exposure of $40trn, and current Dollar price of bonds of $105.6, indicates that, to first order, a 100bp shock to interest rates would translate into a market value loss estimate would be $2.4 trillion.
That is the part Garzarelli forgot to write about. Which is ironic, because in trying to paint a bullish picture, the Goldman strategist in effect admitted that not just the Fed, but the entire world is trapped: should the global economy continue to contract, global bond yields will continue to sink, with trillions more bonds going negative yield, leading to even more debt issuance, and resulting in a ZIRP (and NIRP) trap from which there is no escape.
On the other hand, if – as Goldman hopes – inflation does materialize, however briefly, the resultant MTM loss will be staggering. Keep in mind that $2.4 trillion is only in the US. Now add tens of trillions of record low yielding global debt, including some $10.5 trillion in engative yield bonds around the globe, and one can make the case that the global MTM hit from an even 1% rise in rates would be somewhere between $5 and $8 trilion dollars!
So, according to Goldman, here is the rather unpleasant choice facing the world: continue slowly sinking into a deflationary singularity, coupled with ever greater systemic leverage which makes escape from the ZIRP/NIRP trap impossible as social unrest builds up and ultimately spills over into the streets, or unleash an inflationary impulse, one which crushes countless debt holders, leads to trillions in losses, and requires yet another consolidated bailout…. oh, and also more social unrest.
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