We highlighted yesterday how Deutsche Bank believes that U.S. treasury yields could fall another 50 basis points (0.50%) due to a fresh bout of quantitative easing (QE) from the Federal Reserve. Societe Generale also has shown how hedge funds have now become net-long U.S. treasuries.
Yet Goldman adds a different angle — Markets are already pricing-in a new round of QE, most importantly the U.S. government bond market. This means that the current U.S. 10-year yield, around 2.5% could actually be the bottom for yields, which means the peak for the government bond rally.
They won’t go down to 2%:
Goldman Sachs’ Michael Vaknin:
Can 10-yr USTs Revisit 2%?
With 10-yr US Treasury yields now back at the 2.50% area, many market participants are now toying with the idea of an extended rally towards 2% and possibly even below. Feeding our GS Bond Sudoku model with our below-consensus US growth forecasts (we expect inflation and growth to average at 0.8% and 1.9% respectively) and our better-than-consensus global growth estimates, suggest a ‘fair value’ of 2.9%. The fact that the 10-yr rate currently trades almost one standard deviation lower suggests that prospects of QE2 are already priced in.
Reinforcing this point, the 5-yr tenor is very depressed relative to 2s and 10s, controlling for macro factors. Even if we account for the risk of a more delayed start to the next tightening cycle in Europe (our baseline calls for renewed tightening mid-next year), the fair value for US Treasuries would fall to 2.6-2.7% – still well above 2%.
Nonetheless, the market is focused on the chance of an extended rally towards 2%. After all, these yield levels were already reached back in Dec-08/Jan-09. Below we argue that benchmarking the current price action to the post-Lehman lows is very deceiving; although the macro backdrop today is broadly the same as in early 2009, risk aversion was materially higher at the time.
It’s all priced-in they say, and if ‘fair value’ for the 10-year is at 2.9% yield, then government bond prices are currently too high and we’re likely near a peak for government bonds.
For some perspective, here’s what’s been the three-decade bull market for 10-year government bonds. The 10-year yield fell from 15.8% to 2.5%:
(Excerpt above via Goldman Sachs, Global Markets Daily, 1 October 2010)