Goldman says bond market decline is coming, but it won’t match 1994

Goldman Sachs made it clear that it thinks Treasury rates will rise when it suggested shorting 10-year Treasurys earlier this month. But what it didn’t mention was the resulting price collapse wouldn’t be that bad.

The global investment bank followed up on Wednesday in a report titled A bond sell-off as damaging as 1994? Not Likely. Goldman  GS +0.11% reiterated that it thinks 10-year rates will rise substantially: to 2.50% by the end of 2013 and to 3% by the end of 2014. As a reference point, the 10-year Treasury 10_YEAR -0.47% is currently trading around 1.71%.

The resulting sell-off, though, wouldn’t be as painful as 1994, when the Federal Reserve surprised the bond market by raising the 10-year interest rate to 6% from 3% over the course of a year. A so-called “bond massacre” followed, spurred by the the knee-jerk policy move and the exposure of leveraged balance sheets to the bond market.

But less leverage and less ability to surprise the market make this price collapse different from 1994, according to the report.  Says Goldman:

“The possibility of a 1994-style move in short rates over the next 12 months or so is more or less impossible, in our view, so the real risk today is much more about a sharp increase in longer-dated yields, and the impact that may have on leveraged exposures. In terms of the size, the scope for a similar move in longer-dated bond yields certainly exists. But the seachange in the Fed’s operation and communication strategies makes us more confident that the Fed is not likely to be focused on intentionally surprising markets. Moreover, in the event that yields do start to climb much more sharply than would be warranted by economic fundamentals, it has more tools (communication and an actual purchase program) to moderate the pace of increases. In terms of the underlying leveraged exposures, there are further important differences between 2012 and 1994, most of which point in the direction of a more reassuring conclusion: (i) a much larger fraction of the fixed income market seems to be in the hands of unleveraged market participants; (ii) leveraged holders – US banks – have a significantly smaller portfolio weight in [U.S. Treasurys]; and (iii) bank leverage itself has declined.”

It is worth noting that experts are far from agreed when it comes to interest rates. Bank of America joined Goldman, and apparently Yogi Berra, in suggesting that a Great Rotation will perpetuate a sell-off. But others, like bond specialists Bill Gross of Pimco, have taken the opposite position and declared now a good time to go long on 10-year Treasurys.

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