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Goldman’s ‘Baby Bear Market’ Hides a Mundane Call on Bonds

Brian Chappatta
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Goldman’s ‘Baby Bear Market’ Hides a Mundane Call on Bonds

(Bloomberg Opinion) -- I don’t envy Wall Street strategists this time of year. Correctly predicting the future is obviously difficult, and yet they’re expected to lay out the path forward for each asset class during the next 12 months and recommend trades to profit from those views. 

To make things even more challenging, bank analysts are under increased pressure to prove their worth by making flashy forecasts that, in theory, will attract more media coverage and win more clients. That can be tough to do if their base-case is relatively boring.

This all serves as background for how it’s come to the point that Goldman Sachs Group Inc. is forecasting a “baby bear market” in bonds in 2020. 

If that sounds like a borderline oxymoron, it’s because the strategists appear to be walking a fine line between being provocative (I’m writing about it, aren’t I?) while also calling for a relatively small move in the $16.5 trillion U.S. Treasury market. The group’s forecast is for the benchmark 10-year Treasury yield to “rebound to 2.25%, mostly skewed toward the second half of 2020.” The 10-year U.S. inflation breakeven rate may rise too, they say, though “levels beyond 2.0% look tough to achieve.”

To be clear, those predictions seem perfectly rational. They’re certainly in line with the market’s general stance that the Federal Reserve is firmly done with interest-rate moves after it’s “mid-cycle adjustment” that cut the fed funds rate 75 basis points. An increase in 10-year yields by about 50 basis points would suggest that the central bank was successful is staving off an economic slowdown with its three rate cuts. The benchmark 10-year Treasury yield was 2.25% as recently as May.

But couching that forecast in the language of a “bear market,” even a “baby” one, runs the risk of misleading investors on what such an increase in Treasury yields would mean. 

As a reminder, Bill Gross declared “bond bear market confirmed” in January 2018 after the 10-year yield surged past 2.5%, citing broken 25-year trend lines. Jeffrey Gundlach, DoubleLine Capital’s chief investment officer, said last year to watch for the 30-year yield to close above 3.22% twice to signal the end of the bull market. It stayed above that level for two months, from early October to early December.

And yet, when the dust settled on 2018, the Bloomberg Barclays U.S. Treasury Index still posted a gain of 0.9%. The 10-year Treasury note itself was flat on the year, with the increase in yield (and drop in price) countered by interest payments. As I wrote last New Year’s Eve, the bond bear market never really came.

If you subscribe to the more traditional definition of a bear market — a decline of 20% or more over a sustained period — it wasn’t even a close call. Similarly, the “baby bear market” that Goldman envisions won’t be in the ballpark, either.

The bank’s strategists noted that in both mid-cycle adjustment episodes of the 1990s, 10-year Treasury yields moved substantially higher in the year after the final rate cut, though the slope of the yield curve from two to 10 years barely budged, meaning the maturities moved in parallel. They see that as less likely this time because virtually no one expects the Fed to raise rates anytime soon, keeping the front end of the curve locked in place.

But for the sake of argument, suppose shorter-term yields also rise by 50 basis points by the end of 2020. Even then, two-year Treasuries would still post a positive return of 1.23%. Five-year Treasuries would be flat. The 10-year benchmark would have a negative 1.9% total return. And based on the composition of the Bloomberg Barclays U.S. Treasury Index, this sort of scenario would spell a loss of about 1%.

Maybe you consider a 1% overall loss a baby bear market. It would be the first annual decline since 2013, after all. What I see is a Treasury market that’s up about 10% in 2019 and probably due for a pullback. The index has had a negative total return in just four years dating back to 1973. In three of those four instances, it posted a double-digit gain during the previous year, as it might do in 2019. In other words, it’s not uncommon for bonds to take a breather after a relentless rally, particularly after a year like this one, when 30-year yields fell to an unprecedented low.

It’s possible that as more Wall Street forecasts come in, other strategists will make the case for a more sizable and prolonged bond sell-off. But I’m not so sure, judging from early reports like this one from NatWest Markets strategists led by John Briggs:

“Just about every year, we lay out a list of both upside and downside risks to the rate outlook. This year, we are struggling to come up with strong upside risks. Moreover, even if upside rate risks were realized ... we think the magnitude of the sell-off would be relatively muted. Thus the amount yields may rise in that equilibrium is less than the potential amount yields can fall in any of our downside risk scenarios, of which there are many. In sum, in a best case scenario we think yields have limited room to rise but in the more severe downside risk scenario, yields can fall substantially.”

For what it’s worth, NatWest is hardly a perma-bull on Treasuries. As for Goldman, it has tended to be more hawkish and have more optimistic U.S. growth forecasts than its peers. For instance, as of early December 2018, it was still calling for four Fed rate increases this year. In a Nov. 20 report, strategists led by Jan Hatzius predicted real U.S. gross domestic product growth of 2.3% and 2.4% in 2020 and 2021, respectively, compared with the consensus estimates of 1.8% and 1.9%.

In any case, this isn’t the backdrop for a reckoning in Treasuries. Not even a “baby” one. 

To contact the author of this story: Brian Chappatta at bchappatta1@bloomberg.net

To contact the editor responsible for this story: Daniel Niemi at dniemi1@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.

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