As of a few hours ago, Goldman's Francesco Garzarelli has offi­cially told the firm's clients to go ahead and short 10 Year Trea­surys via March 2012 futures, with a 126–00 tar­get. While Garzarelli is hardly Stolper (and we will have more on the lat­est Stolper­ing out in a sec­ond), the fact that Gold­man is now openly buy­ing Trea­surys two days ahead of this week's FOMC state­ment makes us won­der just how much of a rates pos­i­tive state­ment will the Fed make on Wednes­day at 2:15 pm. From Gold­man: "Since the end of last August, we have argued that 10-yr US Trea­sury yields would not be able to sus­tain lev­els much below 2% in this cycle. Yields have traded in a tight range around an aver­age 2% since Sep­tem­ber, includ­ing so far into 2012. We are now of the view that a break to the upside, to 2.25–2.50%, is likely and rec­om­mend going tac­ti­cally short. Using Mar-12 futures con­tracts, which closed on Fri­day at 130–08, we would aim for a tar­get of 126–00 and stops on a close above 132–00." As a reminder, don't do what Gold­man says, do what it does, espe­cially when one looks the firm's Top 6 trades for 2012, of which 5 are los­ing money, and 2 have been stopped out less than a month into the year.

What is Goldman's ratio­nale for short­ing 10 Years?

At this stage of the cycle, growth expec­ta­tions are in the driver’s seat: The value of inter­me­di­ate matu­rity gov­ern­ment bonds can be related to expec­ta­tions of future pol­icy rates, activ­ity growth and infla­tion, and a ‘risk fac­tor’ highly cor­re­lated across the main coun­tries. These sim­ple rela­tion­ships are cap­tured by our Sudoku econo­met­ric frame­work for 10-yr matu­rity yields. In com­ing months, we expect effec­tive overnight rates to remain close to zero in the main cur­rency blocs (US, Japan, Euroland, and UK) and retail price infla­tion to hover around 1.5–2.0% – con­sis­tent with the for­wards and cen­tral banks’ objec­tives. With pol­icy rates and infla­tion ‘dor­mant’ at this stage of the busi­ness cycle, bond yields (and the 2–10-yr slope of the yield curve) will likely react mostly to shifts in growth expectations.

Bond val­u­a­tions are already stretched rel­a­tive to con­sen­sus growth expec­ta­tions: Around the turn of the year, the out­look on eco­nomic activ­ity was buf­feted by cross-currents reflect­ing the adverse credit con­di­tions in the Euro area on the one hand, and the upward revi­sions to US GDP growth on the other. Our Sudoku model, which helps us trade-off these shifts, indi­cates that 10-yr gov­ern­ment bond yields are cur­rently trad­ing too low (to the tune of 50-75bp) when mapped against pre­vail­ing macro expec­ta­tions. Tak­ing into account the cumu­la­tive impact of the Fed’s secu­rity pur­chases, the degree of mis-valuation of 10-yr bonds is roughly the same across the main regions.

Bond yields are lag­ging the improve­ment in indus­trial activ­ity seen since late 2011: The momen­tum of our Global Lead­ing Indi­ca­tor (GLI) for the indus­trial cycle bot­tomed out in the fourth quar­ter of 2011, although the revised series after the lat­est data show it steadily improv­ing through the sec­ond half of last year. The sequen­tial improve­ment has extended into this year. We observe that, since pol­icy rates have been floored in early 2010, inter­me­di­ate matu­rity yields have tended to lag improve­ments in the GLI by around 2–3 months. With cen­tral banks on hold pro­vid­ing ‘carry’, fixed income investors may have been wary to trade on early cycli­cal sig­nals until these received val­i­da­tion in the early ‘hard’ data.

Real rates (and the 2–10 curve) could play catch-up with cycli­cal stocks: We have iden­ti­fied a rel­a­tively tight pos­i­tive rela­tion­ship between the rel­a­tive per­for­mance of US cycli­cal stocks vs. defen­sives (as cap­tured, for exam­ple, by our US Wave­front Growth equity bas­ket), and the 2–10-yr slope of the Trea­sury curve. The depar­ture from this rela­tion­ship since the turn of the year is now eye-catching. Cycli­cal stocks have strongly out­per­formed the broader mar­ket, a move prob­a­bly ampli­fied by posi­tion­ing, while bond yields have barely moved, under­pinned by US domes­tic investors’ con­tin­ued attrac­tion for ‘carry’ strate­gies. At a closer inspec­tion, yields out to the 5-yr matu­rity have con­tin­ued to decline in real terms, and are now in deeply neg­a­tive ter­ri­tory (-150bp in 2-yr and –100bp in 5-yr, near the early Novem­ber lows), while 5-yr 5-yr for­ward rates are barely above zero. Our esti­mates sug­gest that for­ward rates (5-yr 5-yr for­ward) are now too low. Inci­den­tally, the fact that a poten­tial rise in yields would come from a depressed base and mostly in response to an improve­ment in growth prospects (which should also influ­ence earn­ings growth expec­ta­tions) means that a fixed income sell-off should not pose a threat to the equity market.

The FOMC state­ment could pro­vide a near-term cat­a­lyst: Accord­ing to a client sur­vey by our US trad­ing desk, around half of those polled expect the Fed announce­ment to ease finan­cial con­di­tions fur­ther, with only 12% expect­ing a tight­en­ing. Around two-thirds of par­tic­i­pants believe the mid-point of the ‘cen­tral ten­dency’ range for the Fed funds rate at the end of 2014 will be 75bp (the for­wards) or below. Finally, 72% of respon­dents expect the FOMC will announce a long-run neu­tral pol­icy rate of less than 4%. These results are con­sis­tent with our impres­sion that Wednesday’s announce­ment is now largely dis­counted to rep­re­sent an ‘eas­ing event’. With the data improv­ing, trea­sury yields below ‘equi­lib­rium’, cur­rent coupon 30-yr mort­gage yields at all-time lows, and dis­cus­sions on pol­icy eas­ing shift­ing to ways to sup­port the improve­ment in the hous­ing mar­ket more directly, such expec­ta­tions may be dis­ap­pointed, in our view.

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