Goldman Says Get Ready for Higher Real Yields, Bond Volatility

Get ready for a fresh volatility-threatening selloff in a corner of the Treasury market that holds big sway over global risk assets.

Goldman Sachs Group Inc. is projecting the U.S. economic revival will send longer-dated real yields in the world’s biggest bond market higher by some 40 basis points back toward the pre-Covid business cycle.

“The key driver of longer-dated rates volatility from here might be real yields,” said Christian Mueller-Glissmann, the bank’s managing director of portfolio strategy and asset allocation. “They are too low to reflect the fundamental picture. We are entering the incredible strong second quarter where we expect year-on-year global growth to be among the strongest on record.”

Goldman Says Get Ready for Higher Real Yields, Bond Volatility

Before this month’s head-scratching reversal, a bearish repricing across the Treasury curve this year has been taking Wall Street by storm. The thinking goes that the market risks being caught off-guard if rates adjusted for inflation stage a spirited recovery.

All that has the potential to undercut expensive stock and credit valuations while intensifying the competition for capital -- even if monetary conditions remain historically accommodative.

As the pandemic fallout spurs the Federal Reserve to double down on stimulus, 10-year Treasury Inflation-Protected Securities remain deep in negative territory at around minus 0.79%. These levels -- far below the long-term average -- may well be justified given still-contained core inflation but they look jarring given the U.S. economy is expected to grow by 6.3% this year.

After turning positive in February, market expectations for five-year real yields in five years time are currently at 0.31%, around 35 basis points below the decade average, according to data compiled by Bloomberg.

Goldman Says Get Ready for Higher Real Yields, Bond Volatility

“Real yields are still 40 to 50 basis points below the average in the five years before the Covid-19 crisis, when investors were generally quite bearish on long-term growth prospects,” said Mueller-Glissmann. “This repricing does not all have to happen near-term, it might happen over several quarters.”

Volatility in the rates market therefore has room to run “and it could drive at least temporary indigestion for other assets,” he added.

At the same time, investors are entering a world of economic uncertainty, with the health of the business cycle and the central bank’s reaction function going forward big unknowns. How fast will the labor market roar back? What will the structural impact of the pandemic be on inflation dynamics? On those questions and more, there’s a division in market views on Wall Street, with year-end yield forecasts for 10-year Treasuries ranging between 1% and 2.5%.

To hedge portfolios, the Goldman strategist is telling clients to trade options on interest rates that position for higher yields, known as payer swaptions, or by going long Treasury volatility.

“The market has built up decent amount growth, inflation, and Fed rate hike expectations,” he said. “If all of those expectations unravel, volatility could be more elevated. Yields at current levels can generate more potential for rate volatility in both directions than when they were near zero.”

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