Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Goldman Sachs: Short Treasurys


Everyone is talking about the note from Goldman's Francesco Garzarelli advising that investors short U.S. Treasurys.

The note (via BI):

Since the end of last August, we have argued that 10-yr US Treasury yields would not be able to sustain levels much below 2% in this cycle. Yields have traded in a tight range around an average 2% since September, including so far into 2012. We are now of the view that a break to the upside, to 2.25-2.50%, is likely and recommend going tactically short . Using Mar-12 futures contracts, which closed on Friday at 130-08, we would aim for a target of 126-00 and stops on a close above 132-00. Our rationale is as follows:

At this stage of the cycle, growth expectations are in the driver’s seat. The value of intermediate maturity government bonds can be related to expectations of future policy rates, activity growth and inflation , and a ‘risk factor’ highly correlated across the main countries. These simple relationships are captured by our Sudoku econometric framework for 10-yr maturity yields. In coming months, we expect effective overnight rates to remain close to zero in the main currency blocs (US, Japan, Euroland, and UK) and retail price inflation to hover around 1.5-2.0% – consistent with the forwards and central banks’ objectives. With policy rates and inflation ‘dormant’ at this stage of the business cycle, bond yields (and the 2-10-yr slope of the yield curve) will likely react mostly to shifts in growth expectations.

Bond valuations are already stretched relative to consensus growth expectations: Around the turn of the year, the outlook on economic activity was buffeted by cross-currents reflecting the adverse credit conditions in the Euro area on the one hand, and the upward revisions to US GDP growth on the other. Our Sudoku model, which helps us trade-off these shifts, indicates that 10-yr government bond yields are currently trading too low (to the tune of 50-75bp) when mapped against prevailing macro expectations. Taking into account the cumulative impact of the Fed’s security purchases, the degree of mis-valuation of 10-yr bonds is roughly the same across the main regions.

The basic premise here is that the economic picture appears to be getting better. Europe seems to be muddling through its troubles.

Growth prospects in the U.S. are brightening after we dodged a recessionary double-dip in 2011. The stock market has been booming.

This is ordinarily a recipe for people to start moving out of Treasurys — although so far yields haven't show that.

So Goldman's call here is basically a mean reversion call. There's a disconnect between the behavior of equities and the behavior of Treasury bonds. Goldman thinks, at least in the short term, the equity markets will win out and Treasury yields will rise.

The caveat to this, however, is that Treasury yields can be manipulated by the Federal Reserve . If the Fed is uncomfortable with rising yields, it can push them right back down. So shorting Treasurys requires speculation not only about the direction of private markets, but about policy as well.

Are we sure The Bernanke will allow a break to the upside like this?

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