Forget what you might have heard. There is no bubble in the US government bond market, according to Goldman Sachs.
And how has Goldman come to this rather surprising conclusion? With the help of Sudoku, the popular logic-based number-placement game, of course.
Here’s what Francesco Garzarelli, chief interest-rate strategist at Goldman in London, has been telling clients on Thursday.
In the investment debate typical of this time of the year, we repeatedly hear talk of a ‘bubble’ in government bonds. We disagree and here is why.
The trough of economic activity in the advanced economies could be only 3-to-6-months away, and greater policy activism has restored some confidence in the business outlook and reduced financial distress entering the New Year. Nonetheless, we see the US economy expanding below its potential for the next 6-to-8 quarters, resulting in progressively lower ‘core’ inflation. As regular readers of our research know from our weekly Snapshot updates, by mapping 1-yr ahead macro expectations to long-dated government yields through our Sudoku framework we find that global bonds are, in the aggregate, currently trading close to the model’s measure of ‘fair value’ (see charts below).
Granted, as the year progresses and investors’ focus shifts to the prospects for recovery into 2010, Sudoku does indeed indicate that equilibrium yields will likely drift a bit higher. This is in line with our baseline forecasts, envisaging 10-yr UST and Bunds both trading at around 3.00-3.25% by yearend, JGBs at 1.00-1.25% and Gilts at 3.50-3.75%. But the starting point is not stretched as some assume.
But what about the all that bond issuance coming down the slipway? Surely that will drive prices lower and yields higher? Wrong again. Mr Garzarelli says there is no evidence to support that view.
As we argued in October (see: Fixed Income Monthly: ‘Larger Supply No Threat for Bonds’) there is very weak international evidence that a greater supply of government paper has historically had any meaningful or lasting impact on the absolute level of bond yields once macroeconomic conditions are accounted for (although there may be shifts in the pricing of government paper relative to that of other fixed income securities). In our view, the extra supply will end up being owned mostly by domestic banks, which currently have historically low holdings of government paper.
And he reckons quantitative easing US-style will provide further support for bond prices.
As US policy rates have fallen to their zero nominal bound, the long-end of the government bond curve has itself become a ‘policy tool’. This has been made clear by the latest FOMC statement indicating that ‘the Committee is evaluating the potential benefits of purchasing longer-term Treasuries’.
In summary then:
First and foremost, we take issue with the notion that the government bond market is currently ‘bubbly’. Near term, we think Treasuries will trade in a 2.50-2.75% range through the end of the first quarter. German Bunds yields may fall again to around 3% in the coming months. Moreover, we believe that the high supply will likely change the relative pricing of government bonds relative to other fixed income instruments, but not meaningfully affect absolute yields. With headline CPI inflation forecast to fall into negative territory in the months ahead, uncertainties over when private lending will recover and the Fed committed to using its balance sheet more aggressively, the risks remain skewed towards lower yields relative to our baseline projections.
Got all that? There is no bubble in US government debt market.
Related links:
Tide turning for Treasuries - FT Alphaville
Treasuries bubble danger - FT Alphaville
