Shares of exchange-traded funds that buy U.S. Treasury bonds with long-term maturities fell Monday, after three straight weeks of declines, as Goldman Sachs Group analysts forecast the Federal Reserve may cut interest rates next year.
The Federal Open Market Committee could cut rates due to “a recession, a moderate growth scare, or a convincing decline in inflation,” said U.S. economic analyst David Mericle in a Goldman Sachs research note dated Aug. 13. “Our baseline forecast calls for the FOMC to start cutting” the federal-funds rate in the second quarter of 2024 due to “a desire to normalize the funds rate from a restrictive level once inflation is closer to target, not by a recession.”
The Fed has been raising interest rates at a slower pace this year as it aims to bring down inflation that’s been easing, but remains above its 2% target. Long-term Treasury bond ETFs have seen losses in 2023, with the central bank continuing to tighten its monetary policy against the backdrop of a resilient U.S. economy.
“Normalization is not a particularly urgent motivation for cutting” rates, said Mericle, “and for that reason we also see a significant risk that the FOMC will instead hold steady.”
Meanwhile, the Vanguard Long-Term Treasury ETF VGLT and iShares 20+ Year Treasury Bond ETF TLT each fell 0.2% on Monday, according to FactSet data. The iShares 10-20 Year Treasury Bond ETF TLH closed down about 0.1%. All three funds finished lower after three straight weekly falls, with each posting year-to-date declines.
So far in 2023, the Vanguard Long-Term Treasury ETF has lost 1.9% on a total return basis through Aug. 11, while the iShares 20+ Year Treasury Bond ETF saw a 2.4% loss. The iShares 10-20 Year Treasury Bond ETF has dropped 1.2% over the same period based on total return data from FactSet.
Yields on Treasurys rise when prices of the U.S. government bonds fall.
The yield on the 10-year Treasury note BX:TMUBMUSD10Y rose 1.5 basis points Monday to 4.181%, after climbing for four straight weeks, according to Dow Jones Market Data. As for shorter term yields, 2-year Treasury rates BX:TMUBMUSD02Y climbed seven basis points Monday to 4.963%, the highest level since July 6 based on 3 p.m. levels.
Although Goldman’s baseline forecast is for the Fed to rate cuts next year, Mericle said “we are far from certain” that the central bank will do so.
He expressed skepticism regarding remarks from New York Fed President John Williams in a New York Times interview last week in which Williams argued that assuming inflation comes down, “if we don’t cut interest rates at some point next year then real interest rates will go up, and up, and up. And that won’t be consistent with our goals.”
Goldman has been skeptical of this argument, which is often heard in markets, since early last year, according to Mericle.
“First, real interest rates should be calculated by subtracting off forward-looking inflation expectations rather than backward-looking realized inflation,” he said. “This is important because while year-on-year core inflation still has about 2 percentage points to fall, inflation expectations — even year-ahead expectations —have already normalized to within at most a few tenths of target-consistent levels.”
“Second, the funds rate itself is not that important for economy activity, which is why we focus instead on broad financial conditions,” wrote Mericle.
In July, the Fed raised its benchmark rate by a quarter of a percentage point to a target range of 5.25% to 5.5%, the highest level in 22 years.
In Goldman’s forecast for the Fed to begin reducing rates next year, the cuts are “motivated by a desire to gravitate back toward neutral as inflation comes down, not to stimulate the economy in response to a negative shock,” according to the note. “We have penciled” in 25-basis-point cuts “per quarter in that scenario but are uncertain about the pace,” said Mericle.
