Investors are underestimating the outlook for inflation, and have pushed Treasury yields too low, according to Goldman Sachs Group Inc.
The yield on benchmark 10-year notes has hovered near 2 percent since the start of the month as traders pared bets that the Federal Reserve will increase interest rates this year. The Federal Open Market Committee cited tepid price pressures as it left policy unchanged in September, when the consumer-price index sank to an eight-month low of minus 0.2 percent, weighed down by plunging energy costs. A bond-market gauge of inflation expectations is sliding toward the least in six years.
“Bonds are discounting too little inflation,” Goldman Sachs analysts led by Francesco Garzarelli wrote in a research note dated Oct. 19. “The negative contribution from energy prices to headline inflation will reverse at the turn of the year while a positive — and growing — one from service prices will become more prominent.”
The yield on the 10-year Treasury note was little changed at 2.02 percent as of 7:21 a.m. in London, according to Bloomberg Bond Trader data. The price of the 2 percent security maturing in August 2025 was 99 27/32.
Probability that the Fed will raise interest rates by the end of this year was at 30 percent, less than half the odds ahead of the Sept. 17 FOMC decision, according to data compiled by Bloomberg. The calculation is based on the assumption that the effective fed funds rate will average 0.375 percent after the first increase.
No Surprises
While Goldman Sachs predicts the Fed will raise interest rates at the Dec. 15-16 meeting, it doesn’t expect policy makers to surprise markets.
“The Fed leadership will provide some additional guidance between now and the December FOMC,” the analysts wrote. “The upward move in the term structure should occur over the next couple of months, rather than abruptly after the hike.”
Goldman Sachs’ analysts including Garzarelli have been warning that Treasurys are too expensive since before Fed policy makers deferred a rate increase last month, when 10-year note yields were closer to 2.2 percent. They also predicted a December liftoff at the time.
Inflation expectations are falling on Main Street as well as Wall Street. The median respondent to the New York Fed’s September Survey of Consumer Expectations predicted 2.73 percent inflation in a year, and 2.84 percent inflation in three years — both record lows in data to June 2013.
The 10-year break-even rate — the gap between yields of fixed-rate and inflation-indexed Treasurys — fell to 1.46 percent, approaching the six-year low of 1.38 percent reached on Sept. 29. The rate was as high as 1.94 in June.
Crude oil has stabilized at around $45 per barrel since the beginning of September, after plunging to a six-year low of $37.75 in August.
Like Goldman Sachs, Commonwealth Bank of Australia sees oil prices rebounding, and picks December for a rate increase.
“Market pundits are accentuating the negative and eliminating the positive,” Jarrod Kerr, a Sydney-based senior interest rate strategist at Commonwealth Bank., wrote in a client note dated Oct. 19. “U.S. headline CPI should be back above 1 percent per annum in a few months.”