Goldman Sachs traders: The long-term bond yields in the US, Europe, and Japan will continue to rise, with the key being the speed; closely monitor Japan's long-term bond auction next week

Goldman Sachs expects global long-term interest rates to continue rising, with a rapid increase potentially triggering systemic risks.

On May 25, Goldman Sachs macro traders Cosimo Codacci-Pisanelli and Rikin Shah released a research report indicating that this week's market focus is on long-term interest rates. Although the United States, Europe, the United Kingdom, and Japan face different pressures, the underlying global commonality is very clear: high fiscal deficits, increased bond supply, and a decrease in structural buyers, leading long-term interest rates to become the main pressure "release valve" in the market.

Goldman Sachs warns that unless there is a significant shift in fiscal or monetary policy, global long-term interest rates will continue to rise, and the speed of this increase will be crucial. If the rise accelerates, it could impact the stock and foreign exchange markets, becoming a potential "trigger for systemic risks."

Concerns about the sustainability of the U.S. deficit remain, with expectations that the yield on 30-year U.S. Treasuries may exceed 6%, posing systemic pressure on asset pricing. Although the current pace of interest rate increases is slow and volatility is low, limiting the impact on the stock market, which has only shown a slowdown in growth, a rapid rise in long-term interest rates could trigger a significant stock market decline, tighten financial conditions, and even lead to systemic risks akin to triggering a circuit breaker mechanism.

Weak economic data in Europe, declining inflation, and escalating trade conflicts have made a rate cut in June a foregone conclusion. In the UK, inflation in the services sector exceeded expectations, reinforcing a hawkish stance, but the market's reaction has been muted. Attention should be focused on the April wage data to be released in mid-June; if it slows down, it will support continued rate cuts. If wages remain high, expectations for a rate cut in August may be shaken.

Japan faces similar long-term structural risks as the UK, with life insurance institutions shifting from being the largest buyers to net sellers, compounded by the government increasing bond issuance and the central bank adopting a dovish stance, exacerbating supply-demand mismatches, and there are no signs of policy adjustments from the Bank of Japan. Next week's auction of long-term Japanese government bonds is worth close attention.

I. United States: Rising Long-Term Interest Rates as a Legacy of Fiscal Deficits

Goldman Sachs points out that market concerns about the sustainability of U.S. fiscal policy have never truly disappeared. As the probability of an economic recession decreases, concerns about fiscal sustainability have resurfaced with the passage of Trump's new fiscal bill in Congress.

From the details of the bill, overall, it will not further expand the deficit on paper (after accounting for expected tariff revenues), but there is also no willingness to reduce borrowing. The structure of the bill is "fast tax cuts, slow spending cuts," meaning that the scale of tax cuts is higher than expected and more concentrated in the early stages, while spending cuts are more inclined to be implemented later.

This leaves the market pessimistic about the future path of deficits, which is enough for Moody's to decide to downgrade the U.S. credit rating, and Goldman Sachs believes this is more of a result than a cause.

At the same time, Treasury Secretary Yellen's tone has changed; earlier this year, she strongly supported fiscal consolidation, but there has now been a noticeable shift.

Initially, the U.S. government aimed to keep the fiscal deficit at 3% of GDP. Now, it is shifting blame, claiming this is a mess created by the previous administration, even emphasizing that "we haven't allowed the deficit to continue worsening" as an achievement. Goldman Sachs points out that it seems maintaining a 7% deficit may become the norm for the U.S. in the future Currently, the United States has the worst combination of "weak growth and high inflation" among all developed countries. The exceptionalism of the U.S. is gradually fading, making long-term interest rates and the U.S. dollar exchange rate a "pressure relief valve," so the market is beginning to reprice long-term interest rates.

How to remedy this? What can be done to stop the continued rise of long-term interest rates? Goldman Sachs has listed five possible ways:

(i) Reduce government spending, but the current political atmosphere does not support this; the government is still talking about prioritizing development and stimulating the economy.

(ii) Intervention by the Federal Reserve or the Treasury. They may increase the scale of Treasury bond repurchases in the next quarterly refinancing announcement (QRA), but this tool is only a short-term adjustment and not a real way to suppress long-term interest rates.

(iii) Policy incentives to increase demand for U.S. Treasuries. For example, relaxing regulations (such as SLR requirements) or continuing to provide tax cuts for institutions buying bonds; these policies are already being promoted.

(iv) The safe-haven function of U.S. Treasuries is being reassessed. If market volatility increases in the future, people may start buying U.S. Treasuries as a safe haven again, but this depends on the return of correlation.

(v) A significant deterioration in macro fundamentals. For example, a sudden economic downturn or financial risks could trigger a wave of interest rate cuts, driving rates downward.

Goldman Sachs pointed out that currently, none of the five mentioned brake methods can truly support the market, so long-term interest rates will continue to rise. However, the speed of interest rate increases is crucial:

The current rate of increase is slow and the volatility is low, which has a limited impact on the stock market, so U.S. stocks are only slowing down in their upward trend and have not yet turned downward or experienced a significant decline.

If interest rates accelerate upward, it could trigger a sharp decline in the stock market and tighten the Financial Conditions Index (FCI), potentially causing systemic shocks similar to triggering a circuit breaker. It is worth noting that if the U.S. dollar continues to depreciate, it can buffer the financial tightening pressure caused by rising interest rates.

So how high can the 30-year U.S. Treasury yield go? Goldman Sachs summarized that with a potential growth rate in the U.S. of 2% to 2.5%, an inflation rate of 3%, and a long-term deficit close to 7%, the 30-year U.S. Treasury yield is more likely to approach 6% rather than 5%. In fact, the 30-year U.S. Treasury yield has already surpassed 5% for the first time since October 23 of last year.

II. Europe: Weak data, escalating trade conflicts, pushing for continued rate cuts

Goldman Sachs stated that the market originally thought that after a trade agreement between China and the U.S. and a rebound in the stock market, sentiment in the Eurozone would improve. However, the Eurozone's May Composite PMI unexpectedly fell below the boom-bust line, the wage growth rate in the first quarter was below expectations, and less than half of last year's peak, coupled with Trump's idea of "imposing a 50% tariff on the EU," has led to market expectations that the European Central Bank's rate cut in June has become a foregone conclusion.

Additionally, as of early May, the immediate forecast value of the GIR inflation prediction model was 3%-3.5%, which is already below the European Central Bank's expectations, indicating that the reality is colder and increasing the risk of inflation falling below the target (the ECB's medium-term inflation target is 2%). Therefore, dovish voices within the ECB, especially ECB Chief Economist Philip Lane, will use this to argue that "we need to continue to cut rates." However, the biggest factor affecting short-term pricing this week is Trump's remarks, indicating a lack of progress in US-EU trade negotiations. Trump has called for a 50% tariff on the EU, a figure that is quite exaggerated and seems more like a pressure tactic to force concessions from the EU in negotiations, further exacerbating the risk of an economic downturn in Europe. The problem is that the conditions proposed by the US are, in Goldman Sachs' view, completely unfeasible for the EU. Therefore, it is very likely that the US will impose higher tariffs on the EU, followed by a counterattack from the EU.

The European Central Bank is likely to lower its economic growth and inflation forecasts at the June meeting. If a 25 basis point rate cut occurs in June, the policy rate will drop to 2%, and the ECB may adopt a more neutral stance. The mainstream view in the market is that the ECB will pause rate cuts in July (the market has only priced in 9 basis points), and even the traditionally dovish ECB member Stournaras supported the idea of "taking a break" in July this week.

If there are indeed hawkish voices, their argument is that core inflation remains stubbornly high; for example, they predict that core inflation will still be at 2.4% in the fourth quarter of this year, higher than the ECB's March forecast of 2.1%. Another hawkish argument is that the easing of trade conflicts has reduced global growth downward pressure. However, Trump's recent call for a 50% tariff on the EU indicates an escalation risk in the US-EU trade war, which may further drag down the economy.

Goldman Sachs suggested last week that going long on the July ECB rate decision is a good trading direction. Currently, the market has priced in a 34 basis point rate cut for July. Although the "asymmetry" is slightly less pronounced, it is still worth holding.

If the ECB pauses rate cuts in July, Goldman Sachs believes the likelihood of suddenly resuming rate cuts in September is very low. If there have already been seven consecutive rate cuts and then a sudden pause, continuing to cut again would seem very strange unless there is very significant new information. Therefore, it is recommended that investors continue to hold long positions on the July rate cut while also shorting short-term volatility.

III. UK: Service Sector Inflation Exceeds Expectations, Central Bank Hard to Turn Dovish

Goldman Sachs states that UK inflation exceeding expectations will give hawks more confidence.

This week, UK service sector inflation significantly exceeded expectations, coming in at 5.4%, well above the market expectation of 4.8% and the Bank of England's forecast of 5%. This provides more reasons for the hawkish representatives within the central bank, such as Pill, to tighten policy, leading to a more cautious monetary policy stance.

Although some dovish views argue that this inflation surprise is mainly driven by volatile items (such as vehicle taxes, airfares, and travel), and that excluding these, the actual level of "core service inflation" is lower than 5.4%. However, Goldman Sachs warns that this seemingly reasonable explanation can sometimes obscure real pressures and should not be easily dismissed.

Currently, wages in the UK remain at a relatively high level. The April wage data (the first quarter of the new fiscal year), which will be released in mid-June, will be a key turning point. Goldman Sachs believes that, as stated by Bank of England Deputy Governor Lombardelli, if the data begins to decline, it will strongly support the Bank of England in continuing to cut rates or even accelerating the pace of rate cuts. Goldman Sachs' GIR team firmly believes that the growth rate of wages in the UK will continue to slow down this year, and that it will decrease faster than the Bank of England expects, for the following reasons:

① Wage growth in the first quarter has already shown a significant slowdown;

② The increase in new wage agreements is lower than last year;

③ There are signs of cooling in the labor market;

④ The Bank of England's DMP survey shows that companies expect future wage increases to decline.

However, Goldman Sachs also warns that if wage data remains stubbornly high, market confidence in an interest rate cut in August will be impacted.

Although inflation data has surged, the market's overall reaction has been relatively calm. Short-term interest rates have not seen significant sell-offs, and compared to previous similar inflation surprises in the UK, this time has been handled moderately.

This indicates that the market's expectations for future downward space in interest rates have been relatively sufficient, currently pricing in only about 60 basis points of rate cuts, leaving limited space for further short positions, while creating "better odds" opportunities for long positions.

Therefore, Goldman Sachs' recommendation is to continue holding long positions in short-term interest rates, but to use options to control risk.

Four, Japan: The largest buyer, life insurance companies, have turned into net sellers, facing structural sell-offs in long-term bonds

So far this year, the yield on Japan's 30-year government bonds has risen by 70 basis points, while the spread between 10-year and 30-year bonds has steepened by 50 basis points since early April, with significant upward pressure on long-term interest rates.

The direct trigger for this week's market weakness was a lackluster government bond auction, with the tail yield on Japan's 20-year government bonds reaching 13.75 basis points, the highest since 1987. The bid-to-cover ratio (demand) fell to the lowest level since 2012.

The decline in demand from Japanese life insurance companies is one of the core factors behind this wave of long-term sell-offs. For the past 4-5 years, life insurance companies have been the largest buyers of long-term bonds, needing to match their long-term liabilities with long-term assets, essentially filling the duration gap.

However, the situation has changed. Life insurance companies have bought too many long-term bonds in recent years, and the duration of their assets has been extended. The recent rise in interest rates has led to a decline in bond prices, while also compressing the duration of liabilities, resulting in the duration gap turning negative, making buying long-term bonds a burden instead.

Goldman Sachs estimates that as of December last year, the average duration gap in Japan's life insurance industry was -1.6 years, and by September 2024, it is expected to be -1.5 years. This decoupling of buyers is likely a structural change, not a temporary adjustment.

More notably, even during the fiscal year-end periods when they would typically increase their positions, life insurance institutions did not return, instead becoming net sellers in February and March.

At this time, the Japanese government is also increasing its bond issuance, but the fiscal situation has shown no improvement. This week, the Japanese government announced that it would delay achieving its "primary fiscal balance" target (i.e., no deficit), which means that debt supply will continue to increase.

What further worries the market is that after April 2, the Bank of Japan's attitude has clearly turned dovish, despite domestic inflation remaining high, with no signs of further interest rate hikes or tightening. As a result, the market is demanding higher term premiums to be willing to take on long-term bonds.

Goldman Sachs points out that this is not a predicament unique to Japan. The UK is a typical example of stepping on a landmine first. At that time, the demand from UK pensions (LDI) for long-term government bonds decreased, coinciding with the UK government's fiscal expansion and a surge in bond issuance, leading to a sell-off in long-term government bonds and a significant steepening of the yield curve The UK Debt Management Office (DMO) has attempted to alleviate pressure by shortening the average issuance period of government bonds (for example, issuing fewer 30-year and 50-year bonds and instead issuing shorter-term bonds), but the market has not responded positively, and long-term interest rate expectations remain close to historical highs. The UK's experience indicates that, in the context of widespread fiscal easing and increased debt supply globally, this situation is a very difficult headwind to bear.

In theory, the Bank of Japan could ease long-end pressure by slowing the pace of quantitative tightening (QT), such as reducing sales and maintaining the scale of bond purchases. However, at present, the Bank of Japan has not released any signals for adjustment. Other optional paths include tightening fiscal or monetary policy, or the macroeconomic outlook may face external deterioration.

Goldman Sachs warns that the supply-demand pattern is unlikely to improve quickly in the short term, and therefore the trend of a steepening yield curve may continue, especially as the upcoming long-end government bond auctions will be key observation points.

Goldman Sachs stated that the most surprising aspect is that the current long-end sell-off has not yet had a significant impact on other macro assets. However, Goldman Sachs expects that at some point, both the stock market and the money market will be affected.

The trend of rising long-end interest rates will continue

Goldman Sachs summarized that this week the market focus is on long-end interest rates. Although the US, Europe, the UK, and Japan each face different pressures, the underlying global commonality is very clear: high deficits, increased bond supply, and a decreasing number of buyers, with long-end interest rates becoming the main "release valve."

This supply-demand mismatch will not explode immediately, but the effects are gradually becoming apparent. Unless there is a substantial change in macro policy or fiscal paths, the trend of rising long-end interest rates will continue.

It is worth noting that the speed of long-end bond sell-offs is crucial. So far, the pace of rising long-end interest rates has indeed suppressed the stock market rebound, but has not yet caused a comprehensive financial tightening.

Currently, US front-end rates are "very uninteresting," with recession expectations declining, the threshold for interest rate cuts becoming higher, and data sensitivity weakening.

In Europe, a rate cut in June has become a foregone conclusion, with slowing wages and stalled trade negotiations opening up space for subsequent rate cuts below 2%.

UK inflation has exceeded expectations, suppressing long positions in short-end rate trades, but the market's mild reaction has instead strengthened long positions' confidence, as the current risks and returns present an "asymmetrical good opportunity."

Japan's situation is very similar to that of the UK, with a sharp decline in long-end demand. Next week's long-end government bond auction in Japan is worth close attention.