Investors in exchange-traded funds (ETFs) that purchase long-term U.S. Treasury bonds encountered a setback on Monday, as three consecutive weeks of declines took a toll. The downward trend was driven by predictions from Goldman Sachs Group analysts, who anticipated a potential cut in interest rates by the Federal Reserve in the coming year.
David Mericle, a U.S. economic analyst at Goldman Sachs, highlighted the underlying reasons that could prompt the Federal Open Market Committee (FOMC) to reduce rates. Mericle stated that a recession, a moderate growth scare, or a significant decline in inflation could all serve as catalysts for such action. In a research note dated August 13, he elaborated further, asserting that the FOMC could commence the reduction of the federal-funds rate in the second quarter of 2024. However, he emphasized that this would occur primarily out of a desire to normalize the funds rate once inflation draws closer to its target, rather than as a response to a recession.
The Federal Reserve has been gradually increasing interest rates this year in an attempt to curb inflation. Despite persistently higher-than-desired levels of inflation, recent data has indicated that it has been receding. Given the resilience of the U.S. economy, long-term Treasury bond ETFs have experienced losses in 2023 due to the central bank's continued implementation of its monetary tightening policies.
Mericle cautioned against overemphasizing the urgency for rate cuts as a means of normalization. He anticipates a significant risk that the FOMC might opt to maintain rates at their current levels instead.
Consequently, on Monday, both the Vanguard Long-Term Treasury ETF (VGLT) and iShares 20+ Year Treasury Bond ETF (TLT) saw a decline of 0.2% according to FactSet data. The iShares 10-20 Year Treasury Bond ETF (TLH) also closed down approximately 0.1%. These three funds consistently reported weekly losses, resulting in year-to-date declines.
In terms of performance in 2023, the Vanguard Long-Term Treasury ETF has incurred a total return loss of 1.9% as of August 11. Similarly, the iShares 20+ Year Treasury Bond ETF experienced a 2.4% decline. Based on total return data from FactSet, the iShares 10-20 Year Treasury Bond ETF recorded a drop of 1.2% during the same period.
It is crucial to note that when the prices of U.S. government bonds decrease, the yields on these Treasurys increase, thereby impacting long-term Treasury bond ETFs negatively.
The Yield on the 10-Year Treasury Note Rises
The yield on the 10-year Treasury note BX:TMUBMUSD10Y increased by 1.5 basis points on Monday to 4.181%. This growth comes after four consecutive weeks of climbing, as per Dow Jones Market Data.
Shorter Term Yields Also Experience Gains
On the same day, 2-year Treasury rates BX:TMUBMUSD02Y rose by seven basis points to 4.963%. This marks the highest level reached since July 6 based on 3 p.m. levels.
Uncertainty Surrounding Future Fed Rate Cuts
While Goldman Sachs' baseline forecast predicts rate cuts from the Federal Reserve next year, doubts remain about this outcome. According to Goldman Sachs economist David Mericle, there is a lack of certainty regarding the central bank's decision.
Skepticism Towards New York Fed President's Remarks
Mericle expressed skepticism about recent remarks made by New York Fed President John Williams during an interview with The New York Times. Williams suggested that if inflation decreases, failing to cut interest rates next year would lead to an increase in real interest rates, which would be inconsistent with their goals.
Goldman Sachs has been skeptical of this argument that is commonly heard in markets since early last year, according to Mericle.
Real Interest Rates Calculation
Mericle highlights two important points when considering real interest rates. Firstly, he emphasizes the need to calculate real interest rates based on forward-looking inflation expectations rather than backward-looking realized inflation. Despite core inflation showing a potential decrease of about 2 percentage points over a year, inflation expectations, including year-ahead expectations, have already normalized to target-consistent levels or very close to them.
Secondly, Mericle argues that the funds rate itself is not significantly crucial for economic activity. Instead, he suggests focusing on broad financial conditions.
The Fed's Move to Increase Rates
In July, the Federal Reserve raised its benchmark rate by a quarter of a percentage point, bringing it to a target range of 5.25% to 5.5%. This rate is the highest level seen in 22 years.
Goldman Sachs' Forecast for Rate Reduction Next Year
Goldman Sachs predicts that the Fed will begin reducing rates next year but not as a response to a negative shock. Instead, the reductions are motivated by a desire to move closer to neutral levels as inflation decreases. According to Mericle, if this scenario unfolds, Goldman Sachs foresees 25-basis-point cuts per quarter. However, there is uncertainty surrounding the pace of these cuts.
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