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Goldman Sachs to Bond Traders: You're Underestimating Inflation

Goldman Sachs to Bond Traders: You're Underestimating Inflation
(Dollar Photo Club)

Thursday, 12 November 2015 12:00 PM

Bond traders should bet that the Federal Reserve will meet its objectives for quicker inflation, say analysts at Goldman Sachs Group Inc.

Sliding energy prices and slowing global economic growth have weighed down a measure of inflation expectations known as the 10-year break-even rate — the gap between yields on Treasury notes and inflation-linked debt of that maturity. The gauge has rebounded from a six-year low set in September, and Goldman Sachs says it’s poised to keep climbing as oil prices stabilize and the U.S. economy accelerates.

The analysts predict that the rate — at about 1.56 percent — will jump to 2 percent, though they don’t specify a timeframe. At that level, the market’s forecast for inflation would match the Fed’s goal, and it would be closer to the 15- year average of 2.1 percent. To profit from the projection, the bank recommends buying inflation-linked 10-year Treasurys versus regular notes.

"The market is way too bearish on U.S. inflation in the medium term," meaning between five and 10 years, said Silvia Ardagna, an analyst in London with Goldman Sachs, one of the 22 primary dealers that trade with the Fed.

A rebound in the bond market’s inflation view would signal rising investor confidence in the Fed’s ability to increase interest rates without derailing the economy. Stronger-than- forecast U.S. jobs data on Nov. 6 backed up the case for the central bank to boost its benchmark rate from near zero at its meeting next month.

A turnaround in the inflation measure could happen quickly because the gauge is so low compared with where the bank assesses fair value — a statistically rare two standard deviations away — according to Ardagna.

"When an asset class in our space is this misvalued relative to its fair level estimated with our model, usually a reversal tends to be pretty fast," she said.

The 10-year break-even rate hasn’t traded at 2 percent since October 2014, when crude oil was above $90 a barrel, compared with about $42 Thursday. Investors should exit the trade if the break-even closes below 1.4 percent, according to the bank.

Price Driver

The bank doesn’t predict a rebound in oil prices anytime soon. And globally, tepid economic growth has prompted the European Central Bank to weigh more stimulus and the People’s Bank of China to step up easing efforts.

"We’ll have a low-inflation world for some time," said Andrew Milligan, Edinburgh-based head of global strategy for Standard Life Investments, which manages $393 billion. "A lot of disinflationary forces are out there."

Yet in the U.S., consumer prices should start rising even if oil stays flat, Ardagna said. That’s because inflation has accelerated in corners of the economy that are shielded from the decline in energy costs and international economic pressure.

In one example, the October U.S. employment report showed the sharpest yearly rise in average hourly earnings since 2009.

What’s more, many metrics of price growth are measured on a yearly basis, so energy may have a smaller impact on the consumer price index. While crude is 45 percent cheaper than a year ago, if it remains at this level for two more months it’ll be down only about 8 percent from a year earlier.

"When the base effects from the decline in energy prices go out of the index, this will become much more visible," Ardagna said.

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Bond traders should bet that the Federal Reserve will meet its objectives for quicker inflation, say analysts at Goldman Sachs Group Inc.
gold sachs, bond traders, inflation, invest
Thursday, 12 November 2015 12:00 PM
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