Episode 87: The Rate Stuff: What Markets Are Saying About the Macro Outlook

Current Market Volatility Drivers

• Volatility in equity and bond markets has surged since February 2018, marking the end of a prolonged low-volatility period.
• The primary catalyst is a market repricing of the U.S. growth outlook following fiscal stimulus measures.
• Investor uncertainty has increased regarding the Federal Reserve's response to stronger growth and the trajectory of terminal interest rates.

Bond Market Dynamics and "Bear Market" Debate

• Goldman Sachs Research does not currently anticipate a genuine bond bear market, defined by synchronized rate hikes across major central banks (Fed, ECB, BOJ, BOE).
• Synchronized tightening is forecast to occur no earlier than late 2018 or early 2019.
• Current bond sell-offs are largely a repricing of the Fed's path, while other central banks remain on different cycles.
• The U.S. real interest rate (TIPS) curve has steepened, but inflation expectations have not risen significantly to build an inflation premium.
• Term premiums are currently depressed in the U.S. due to historical foreign central bank interventions, though premiums are rising in Europe and Japan as quantitative easing (QE) unwinds.

Federal Reserve Policy and Economic Outlook

• The Fed is maintaining its tightening cycle despite inflation remaining below the 2% target, aiming to prevent future excesses.
• Goldman Sachs maintains a forecast of four rate hikes in 2018, aligning with the Fed's median dot projections.
• Terminal rate expectations have risen to approximately 3% (composed of ~1% real rate and 2% inflation expectation).
• Quantitative Tightening (QT) remains difficult to calibrate compared to rate hikes, with risks stemming from increased Treasury issuance and potential inflation spikes.
• The Fed is responding to stronger global growth and the near-elimination of spare capacity, which raises expectations for future wage and consumer price inflation.

Risk Assets and Inflation Scenarios

• Risky assets have held up despite bond market sell-offs because markets do not currently price in a significant break of the 2% inflation target.
• Goldman Sachs forecasts higher inflation than currently priced in, viewing the current market complacency as an "investable proposition" for volatility trading.
• A statistical metric shows the market assigns only a 10% probability to five-year break-even inflation exceeding 3%, whereas the firm believes historical norms suggest a 30% probability.
• If the Fed miscalibrates and inflation rises faster than expected, correlations between fixed income and risky assets could break down, leading to stress in both asset classes.

Global Monetary Policy Divergence

• The ECB is expected to end its large-scale bond purchase program (QE) in the fourth quarter of 2018.
• As ECB subsidy to the long end of the curve diminishes, investors are divesting from flat U.S. curves and seeking steeper yields in Europe.
• This shift is driving exchange rate dynamics, specifically strengthening the euro against the dollar.

Political Risks and European Markets

• Recent Italian elections resulted in a hung parliament, though markets had already priced in a stalemate.
• Goldman Sachs does not anticipate immediate spillover risks to other European nations due to strong underlying growth and monetary accommodation.
• Systemic risk in the Eurozone has fallen below the average levels seen during the 2011-2012 debt crisis; correlations among peripheral European assets (PIIGS) have decoupled.
• Political volatility in Europe is driven by domestic economic disparities and migration issues, with outcomes shaped by specific electoral systems (e.g., one-round vs. two-round voting).

Forward-Looking Statements and Investment Strategy

• The firm is prepared to remain invested in risky assets given resilient global growth but anticipates higher volatility.
• Investors should expect to exploit "drawdown risk" by taking positions in higher volatility and steeper yield curves where the market pays a premium for risk.
• Potential shocks, such as geopolitical events or growth disappointments in China, could cause a re-steepening of the U.S. yield curve from the front end, potentially lifting risk assets if the shock is contained.
• Treasury issuance is set to increase, and with the Fed buying fewer bonds, bond investors may face adverse conditions if inflation picks up.