Poor Goldman just can’t get anything right these days. Having started off 2016 with euphoric optimism, predicting a soaring dollar and at least 4 rate cuts not to mention a blistering recovery, following a series of hits to the US economy and culminating with the Brexit vote, which as we reported over the weekend prompted Goldman to slash its 2017 UK GDP outlook and to now anticipate a “moderate recession” in the UK in the first half of 2017, and now expects the BoE to announce credit easing policies at its July meeting and to cut interest rates 25bps at its August meeting.
Worse, Goldman has thrown in the towel on its US recovery narrative – again – and has reduced its US forecast by 0.25% in 2016 to 2.0% “and now expect just one further hike by the Fed in 2016 in December.” Putting this in context, the market believes there is a greater possibility of a rate cut than hike in the next two FOMC meetings.
Which naturally means that not only will Goldman soon have to cut its year end S&P forecast if only to prompt the Fed to be more dovish than expected, but will have to cut its year end 10Y forecasts.
Which it did moments ago.
Government bond yields in the major advanced economies moved sharply lower on the back of the largely unexpected news of Brexit. The levels that 10-year rates touched were broadly in line with our previous estimates of what the knee-jerk impact could have been (1.35% on TY10, -10bp on German Bunds, 1.0% on Gilts and BTPs at 1.85-2.00%) although the price action did eventually stabilize. Exhibits 1 and 2 below illustrate movements in 10-year US Treasury and Italian BTP yields since 30 May.
Our empirical analysis, shown in Exhibit 3, suggests that, since the end of May, the largest contribution to the global yields has been the UK Gilts market – which has sent ‘bond-bullish’ impulses to other major markets. At the margin, US Treasuries are not pushing global rates higher as they had been doing in April and May. German Bunds, by contrast, appear to be mostly responding to external forces rather than fuelling the rally on their own accord.
Our Economics team has revised their baseline macroeconomic projections, which were built under a ‘Remain’ assumption. These envisage a 275bp cumulative hit to UK real GDP, prompting a rate cut in August followed by a long period of ultra-low rates and possibly outright purchases of credit instruments; a modest-sized hit to Euro area GDP (50bp below a previous above-trend baseline) and an extension of ECB QE to end 2018; and only one more hike by the Fed this year, with downside risks.
So how does Goldman arrive to this brilliant conclusion, clearly priced in long ago by the market? Why the Sudoku bond model.
Our Sudoku Bond model estimates for the long-run ‘fair value’ of 10-year government bond yields based on the new forecasts falls by around 20bp in the US, around 10bp in Germany, and 5bp in the UK and Japan. As also can be seen from Exhibit 4, however, the gap between the model output and actual yields remains statistically large, ranging between 2.0 standard deviations in the US and Canada to around 1.5 standard deviations in the UK and Germany.
Let’s hope that it is not Goldman’s Sudoky model that is running the Fed’s central planning computer.
Finally, some last words from Goldman on European bonds, and especially Italian bonds where GS is most cautious:
We expect volatility in EMU peripheral markets to persist, amplified by local political events (with the Spanish elections behind us, the focus will now turn to the European responses to Brexit, and the Italian referendum on Constitutional reforms in the Fall). Reflecting the presence of the ECB in the market through the PSPP (which may be stepped up further, and tilted in the direction of more peripheral purchases), and the fact that most peripheral risk in now in the hands of domestic investors (whose ‘discount factor’ is lower than for internationals), we do not expect spreads to revisit levels seen before the start of QE. Using 10-year Italy-Germany as a gauge, 200bp would represent an upper limit (from 160bp on Friday’s close). The term structure of spreads will remain steep, above 50bp for maturities between 5- and 10-years.
One of the fault lines in the Euro area remains peripheral banks and – given the size of the country – especially those in Italy. The comparatively low levels of equity relative to NPLs and the new ‘bail-in’ rules (around half of the EUR160bn bail-inable subordinated bonds are held by households) make the situation particularly delicate. Consider that, in Italy, the so-called Texas ratio (the ratio of bad loans to tangible equity capital plus loan loss reserves) stands at 117%, or around 3-4 times larger than in Germany and France. According to media sources, the Italian government is studying the possibility of injecting as much as EUR40bn into Italian institutions. This would be a large sum, corresponding to around 30% of the equity at book value in the entire banking system. Whether this will come alongside a suspension of the ‘bail-in rules’ (which can happen only at the Euro area level) is unclear at this stage.
From the government bond market standpoint, if this amount of funds were to be raised in markets, it would be a sizeable increase (around 50%) in prospective issuance during H2 2016 and push spreads wider, easily to the top end of the range we gave above (i.e., 200bp). But it is unclear whether the public capital would be funded, or could come from the ESM (which would represent a stronger form of support, but would likely come with added conditionality). All told, as we wrote in recent notes leading up to the UK referendum, Italian bonds look most exposed to these dynamics, and we would still not recommend establishing longs in spite of the wider spreads until these dynamics are clearer.
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