Goldman Sachs Warns of Persistent Risks in Global Long-Term Bonds

Goldman Sachs has released a report highlighting the recent pressures on global long-term bonds, with a particular focus on the Japanese 30-year government bond yield, which has been on a steady rise. The report also underscores the growing concerns over U.S. fiscal issues, which have been exacerbated by the re-emergence of trade and tariff risks towards the end of last week. While the 20 to 40-year Japanese government bonds have shown signs of weakness, this is seen as a localized issue, potentially driven by technical factors. However, this does not diminish the urgency for policy adjustments. Against the backdrop of rising global inflation and high fiscal deficits, Goldman Sachs warns that the risks associated with the sell-off of Japanese long-term bonds are unlikely to dissipate quickly.

In the United States, the firm believes that the situation is similar to that of 2023, which will limit the relief available for the long end of the U.S. Treasury curve. Investors are more inclined to shift any long-term investments towards shorter maturities. However, unlike 2023, the sustainability of the deficit expectations means that market signals will be more dependent on demand factors. The recent downgrade by Moody's, the progress of the fiscal plan in the U.S. Congress, and the global spillover effects have collectively intensified the focus on fiscal risks. Similar to 2023, there is a weakening belief in policy rate cuts, heightened fiscal concerns due to the U.S. downgrade, and bearish sentiment from Japan. However, Goldman Sachs attributes the current risks facing U.S. Treasuries more to the lack of demand for U.S. assets globally, rather than sudden concerns over the scale of the deficit or issuance.

The fiscal bill, while unlikely to significantly alter the deficit trajectory compared to Goldman Sachs' previous baseline, will continue to increase the debt burden in the global freely flowing quantity. The Supreme Court's ruling on the Federal Reserve's "unique structure" last Thursday helped alleviate potential factors contributing to rate volatility and higher risk premiums. However, without adjustments to fiscal policy, more significant relief could come from stabilizing external pressures, a series of self-reinforcing positive demand signals (such as well-received auctions), or renewed confidence in the Federal Reserve's rate cuts to revive duration risk appetite. Friday's tariff news could potentially move in the opposite direction, leading to a preference for shorter-term bonds. If Goldman Sachs' economists' baseline of three rate cuts is realized, there could be an opportunity to increase long positions while hedging higher term premium risks through low-discounted mid-term forward contracts.

The 20-year U.S. Treasury bond was particularly affected. The auction results for the 20-year bond on Wednesday aligned with the rate market's sensitivity to any signals of sustained demand weakness. The 20-year bond performed poorly on the yield curve, trading at lower prices relative to 10-year and 30-year bonds in both the swap and cash markets. This reflects the characteristics of the 20-year bond, which has a larger duration extension relative to the 10-year bond and smaller convexity yield relative to the 30-year bond, often performing poorly during periods of rising volatility and term premiums. However, even considering these factors, the 20-year bond's performance fell short of expectations based on its relationship with volatility and term premiums. While there are reasons to be cautious about the recent drivers of long-term rate volatility, the 20-year bond on the yield curve may offer value to investors looking to position themselves post-recent volatility or seeking some adjustment.

The volatility in long-term Japanese bonds serves as a warning signal for the global bond market. This week, a weak auction of 20-year Japanese government bonds led to another significant drop in long-term Japanese bond prices, continuing the volatile trend since April. As Goldman Sachs noted last week, the long-term price trend of Japanese interest rates is still primarily influenced by technical factors, including adjustments to macro positions and insufficient demand from institutional asset management investors. However, fiscal concerns, continued quantitative easing, and rising inflation pressures all point to a sustained increase in the equilibrium rate, which could have broader implications for global interest rate trends.

So far, the rise in Japanese bond yields has had limited spillover effects on global markets. However, in the current environment of global fiscal concerns and worries about long-term interest rate supply, if this trend continues, the relative attractiveness of Japanese bonds, based on foreign exchange hedging, could pose spillover risks to global interest rates. A potential stopping point for this decline could be reducing long-term supply (for example, if the Japanese Ministry of Finance decides to change its issuance plan), but this could take time. Another possibility is that the Bank of Japan takes a more moderate stance on quantitative easing (possibly combined with a more tightening stance on policy rates). However, regarding the latter, Goldman Sachs notes that the significant reduction in "rinban" (the Bank of Japan's bond purchase operations to manage the yield curve) primarily comes from the middle of the curve, with no substantial change in the Bank of Japan's participation in the long end of the curve.

Therefore, for the Bank of Japan's bond reduction decision to have a significant impact on long-term Japanese bonds, some form of twist operation (where the Bank of Japan effectively increases its purchases of long-term bonds) may be necessary. While this is not impossible and could be driven by stronger evidence of market failure, Goldman Sachs believes that achieving this standard at the upcoming June meeting is relatively high, given the limited spillover effects on other curve segments or Japanese assets. This suggests that the long-term pressure on Japanese interest rates may persist for some time.