Why Goldman Thinks The Fed Isn’t Even Halfway There

Count JPMorgan among those who aren’t particularly concerned with 10Y yields at 3%.

We’ve argued repeatedly over the past week (see here, for instance) that the obsession with the 3% threshold is to a certain extent absurd, although admittedly, when something that’s inherently arbitrary becomes a fixation for enough people, there’s a self-fulfilling dynamic that kicks in, effectively bestowing undue meaning on something that, in and of itself, is largely meaningless.

Yields of course pushed above the February inflation scare highs, although the selloff faded later in the week even as an above-consensus ECI print and PCE reinforced the notion that wage pressures are building while elevated crude prices suggest inflation expectations may have further to run. The spec net short in the 10Y is now at a record according to the latest CFTC data out Friday afternoon:


“The persistent fixation on yield curve flattening and a 3% U.S. 10-year is not one we share,” JPMorgan writes in a new note, adding that “a nominal U.S 10-year of 3%, which is only 0.8% in real terms, seems about 75 basis points away from challenging equities based on the earnings yield/real bond yield framework used by some asset allocators.”

We talked at length (again) about what the “magic” number is beyond which equities can no longer suffer rising long end yields in “Two Reasons To Doubt The Narrative On Yields And Stocks.” Recall that while historical evidence suggests there’s considerable room to run before equities suffer (right pane)…


… and while Goldman thinks 4% is probably the “pain threshold”…


… the post crisis experience suggests that the proverbial line in the sand may be lower than it was pre-GFC:


This debate is playing out ahead of the May Fed meeting. Obviously they’ll be no hike (that comes in June, when a hike is almost fully priced), but the statement will be parsed for signs of further conviction in the rate path, following what was a kind of “baffle them with bullshit” SEP and accompanying dot plot in March.

On Friday, we sarcastically asked if the Fed was poised to hike the economy into recession. There’s more than a little angst right now about the seemingly inexorable flattening in the curve and while there’s considerable debate about the relative merits of basing a trading strategy around the notion that the curve can predict recessions (BofAML calls that foolhardy in a note out late last week, noting that “the long and variable lags between inversions and recessions [shown in the chart below], make it very difficult in practice to base a bond investment decision on an inversion of the curve”), you shouldn’t expect the inversion cacophony to die down any time soon.


Despite the risks seemingly telegraphed by the flattening in the curve (and indeed the first signs of inversion) and despite 2-year yields at their highest since 2008, Goldman notes that based on one model, the Fed may not even be halfway there.

In a note dated Saturday, the bank writes that “if the focus is on the instruments of monetary policy, one may argue that between one-half and three-quarters of the tightening job is now done.” However, they say that an outcomes-based approach tells a different story. To wit:

The Fed’s challenge in hiking cycles is to bring about a policy tightening that is sufficient to slow growth to a trend or slightly below-trend pace but not so large that it tips the economy into recession. And there is still little evidence that the committee is close to the halfway mark from this perspective. To quantify the economic slowing, we look at changes in activity and job growth since the start of the tightening cycle. We pick October 2014 as the start date when the policy-sensitive 1-year Treasury bill yield started to discount liftoff. Our 60/40 CAI/GDP average ran at 3.8% in October 2014 (on a 3-month average basis). With our 60/40 growth signal now at 3¼% and assuming that GDP growth returns to our 1¾% potential estimate, only 25-30% of the growth slowing is already done, as shown in Exhibit 6. Similarly, we estimate that only 25-30% of the slowing in job growth has occurred. Payroll gains have averaged about 210k over the last six months–only 50k slower than the trend in late 2014–and still more than double our roughly 100k estimate of the breakeven rate.


They go on to suggest that between whatever short-lived sugar high the economy gets from fiscal stimulus and whatever’s left of the impulse from still loose financial conditions, the Fed may feel like they’re a long way from having the desired effect when it comes to cooling things off.

If that’s the case, well then Goldman thinks it’s probably wise to pencil in more hikes than you might have previously factored in.

Take that for whatever it’s worth.

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2 thoughts on “Why Goldman Thinks The Fed Isn’t Even Halfway There

  1. “We’ve argued repeatedly over the past week (see here, for instance) that
    the obsession with the 3% threshold is to a certain extent absurd ”

    Yes. There should be more concern about short-term rates jumping, such as the 2’s mentioned in this post.

    Rising short-term rates crushes the profitability of banks and bank like financials who borrow short and lend long.

    Plus much more household and government debt is tied to shorter rates (tho lately gov’t has been trying to extend duration). Stats show household and corporate credit growth falling, probably in response to higher rates on the short end of the curve. If it continues it becomes an early recession indicator approximately on par with an inverting yield curve for reliability as a signal.

NEWSROOM crewneck & prints