Goldman Sachs co-head of global macro and markets Francesco Garzarelli cited the following reasons for the bearish bond view, according to Bloomberg:
1. Bond valuations have been stretched for a while now
The sharp drop in bond yields following the U.K. referendum to leave the European Union has not been justified by a slowdown in economic growth that would normally send investors scurrying into the relative safety of government debt, Garzarelli argues. With Goldman expecting economic activity to pick-up in developed markets, the crowding of investors into government bonds looks odd.
“Over coming quarters, we expect economic activity in the advanced economies to expand at around trend levels, headline CPI inflation to receive a boost from base effects in energy prices, and the Fed[eral Reserve] to raise policy rates – an outcome we believe the market under-prices even for the remainder of this year,” Garzarelli said.
On that basis, 10-year U.S. Treasuries should be trading closer to 2 to 2.25 percent.
The bond bubble will almost certainly deflate at some point soon. Central banks are also running out of bullets to fire at the economy, as well:
2. Quantitative easing is losing influence
Bond purchase programs by central banks have helped compress yields on government debt but that effect may now be waning, Garzarelli argues, with growing realization of the technical restrictions and downsides to unconventional monetary policy now emerging. He cites the example of recent discussions by the Bank of Japan and the European Central Bank as to the limits of unconventional monetary policy.
“There are various reasons why such an assessment is necessary at this juncture. One of them is that the sharp fall in ultra-long dated yields has resulted in costs and distortions counterbalancing the economic benefits of lower real rates,” he said. “Consider that pension and life insurance companies in Europe and Japan have large stocks of defined liabilities and asset allocations skewed towards fixed income products. When long-term rates decline, these financial institutions tend to manage down their risk exposure, rather than increase it.”
And as easing measures lose their effectiveness, investors keep hoping for more and more accommodation. That’s setting them up for a big disappointment:
3. Everyone’s hoping for fiscal policy now
With ever-increasing questions over the willingness and ability of central banks to keep on ‘QEasing’, more investors are looking to government-led measures to help spur economic growth. Expectations of such fiscal measures have been rising in Europe and Japan, despite increasing budget deficits, as well as in the U.S., Garzarelli argues.
“In the U.S., discussions on the possibility of an easier fiscal policy are linked to the outcome of the Presidential election,” he says. “But the market appears increasingly responsive to such moves, as it considers them more effective in supporting final domestic demand when interest rates are close to their effective lower nominal bound.”
So far today, investors don’t seem to worried about Goldman’s warning. The iShares Barclays 1-3 Year Treasury Bond Fund (NYSE:SHY) and iShares Barclays 7-10 Year Treasury Bond Fund (NYSE:IEF) were both mostly flat in Monday afternoon trading.