U.S. Treasury yields bottomed out in July 2012 after three decades of a steady grind lower.
Since then, they have had their ups and downs, but eventually, the yield on the 10-year U.S. Treasury hit a high of 2.06% on March 11, right before the financial crisis in Cyprus blew up and the consensus began to shift its focus to fears over an emerging slowdown in global growth.
That backdrop set the stage for a big rally in Treasuries as investors piled back into them, sending yields all the way down to 1.63% on May 2.
In the last three weeks, however, yields have reversed violently as investors have sold bonds and are once again testing the post-low highs set in early March.
And this time, Goldman Sachs says the bond market sell-off is for real.
“Our bond valuation models (Sudoku and GS Curve) and a separate study of the determinants of US Treasury yields which explicitly accounts for the impact of QE, policy ‘guidance’, uncertainty and the European crisis indicate that intermediate yields should be trading in the upper half of this range, given the decline in systemic risks and the brightening US economic outlook,” write Goldman’s Francesco Garzarelli and Silvia Ardagna in a note to clients this morning. “Our model estimates (and, consistently, our forecasts) show 10-year Treasuries reaching 2.5% in the second half of this year, with German Bunds trading at 1.75%.”
Garzarelli and Ardagna make two assertions central to their case that this time is for real: (1) investors just turned too pessimistic on global growth, halting the previous rise in yields, and (2) the bond market has become more responsive to economic data since the Federal Reserve tied its interest rate policy to specific economic data thresholds in late 2012.
Here is their argument:
We relate the recent sell-off in yields to a shift in expectations that had turned too pessimistic. As we argued in the April issue of our Fixed Income Monthly, 10-year government bond valuations in the major markets had departed from their macro underpinnings in a statistically meaningful way, and the likelihood of a sharp correction had therefore increased. A stronger-than-expected payrolls report acted as a catalyst, compensating for a string of moderately underwhelming economic data (our US MAP score, which compares realisations to economists’ forecasts, improved in May).
More broadly, we find evidence that the US bond market returned to being more responsive to incoming economic information in comparison to the case in the second half of last year (to illustrate, the chart below plots the regression line between the US Map scores and changes in Treasury yields around the data releases). We ascribe this movement to a shift in the Fed’s reaction function. In the second half of 2012, the Fed’s forward guidance on the future path of the policy rate was linked to a specific calendar date. The introduction of ‘macroeconomic thresholds’ in the Fed’s policy guidance last December led investors to focus again on data developments. In this context, we note that market forecasts for 2013 US growth have now clustered around 2%, and that the downside risks have been revised down materially (see chart below).
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