Goldman Sachs believes that market bets on the Federal Reserve raising interest rates are still too hawkish, given the continued decline in inflation in the world's largest economy, along with signs of a slowdown in economic activity.
Jan Hatzius, the bank’s chief economist, said in a note to clients that an interest rate hike at the central bank’s September meeting had become “highly unlikely,” citing weak retail sales data, concerns about labor market performance, and slowing inflation readings.
Hatzius added that the bank's baseline forecasts indicate that inflation data are likely to improve further as the year progresses, rather than deteriorate again, stressing that Goldman Sachs still believes that the markets' pricing of the path of the federal funds rate is overly hawkish.
Traders had pushed back their expectations for the next interest rate hike by 25 basis points to January, after markets had almost fully priced in a December increase just a week earlier, according to data compiled by Bloomberg. While market expectations have softened, Goldman Sachs believes there is still room for further rate hike bets to decline.
Slowing inflation weakens the case for raising interest rates.
Expectations for monetary policy are of great importance to government bond markets around the world, given that decisions by the Federal Reserve often affect interest rate levels in other economies.
Investors in U.S. Treasury bonds are currently facing the impact of two opposing forces. On the one hand, slowing inflation is reviving the appeal of bonds as a more suitable investment in an environment where price pressures are receding, while high levels of government borrowing and persistent concerns about public finances are putting pressure on buyers to demand higher returns in exchange for holding long-term bonds.
This contradiction threatens to keep long-term bond yields high, even as price pressures ease, which could limit the gains that bonds usually make when inflation starts to fall.
Yields on two-year U.S. Treasury bonds, which are among the most sensitive debt instruments to changes in U.S. monetary policy, remain above 4%, as investors continue to assess whether and when the Federal Reserve will resume raising borrowing costs.
Treasury yield curve faces conflicting pressures
Goldman Sachs believes the US Treasury yield curve is poised for further decline, driven by improved inflation data, a lower risk premium associated with interest rate hike expectations, and concerns about the US budget situation.
This suggests that a decline in interest rate hike bets may provide further support for short-term bonds, while long-term bonds remain vulnerable to pressure from rising government borrowing and concerns about fiscal deficits.
Hatzius said that the release of distinctly weaker data on the labor market and inflation over the past two months makes it difficult to imagine Federal Reserve officials, who tend toward a more accommodative monetary policy, shifting toward supporting an interest rate hike.
Goldman Sachs believes that the current picture of the US economy does not provide a strong basis for raising interest rates in September, especially with the combination of slowing inflation, a weak labor market, and declining retail sales, factors that may prompt policymakers to hold off rather than tighten monetary policy again.
