Goldman Sachs Warns of 1979-Style Bond Collapse as Dollar Weakens

Goldman Sachs' chief macroeconomic researcher has warned that the current market dynamics are being driven by a narrative of liquidity, with the dollar's decline mirroring patterns from the 1970s. This situation raises concerns about a potential repeat of the 1979 scenario, where the collapse of long-term bond markets could force policymakers to confront systemic vulnerabilities.

A key structural signal is the first instance in three decades where foreign central banks hold more gold than U.S. Treasury bonds. This shift echoes the late 1960s, when European central banks began questioning the dollar's status and moved towards gold. This change reflects a growing erosion of trust in U.S. government debt.

The dovish stance of the Federal Reserve and expectations of rate cuts are extending the current economic cycle. Easing financial conditions could drive economic acceleration by 2026, providing an upward push for risk assets. This scenario is reminiscent of the mid-1990s, when the Federal Reserve's preemptive rate cuts successfully extended the economic expansion and fueled a stock market rally.

However, the combination of loose liquidity and systemic mistrust is playing out in the market. While liquidity dominates in the short term, the real issue lies in whether long-term rates can remain stable. A sudden disruption in the long-term bond market could force policymakers to address the fragility of the financial system, potentially ending the cycle not through economic weakness but through a loss of trust.

Historically, the Federal Reserve's rate cuts during non-recession periods have often boosted the stock market. In 1984, 1995, and 2019, similar rate cuts successfully drove stock market gains, underpinned by the belief that economic weakness was temporary. The current situation is even more favorable, as part of the Federal Reserve's rate cuts are aimed at correcting previous misjudgments about the labor market. This means the stock market benefits from lower discount rates without needing to adjust economic growth expectations.

In this context, only the rate market is concerned with data corrections, while the stock market enjoys valuation increases. This view is reinforced as long as the labor market slows down rather than deteriorates.

The rise of assets like cryptocurrencies, similar to gold in the 1970s, serves as a hedge against inflation, mistrust, and political disorder. The current surge in gold prices recalls the period from 2008 to 2011, when quantitative easing policies undermined confidence in fiat currencies, driving investors towards hard assets. This mistrust is rooted in systemic factors, such as the rise of populism and inequality, which have eroded social trust in existing systems.

This situation is reminiscent of the 1930s, when elites hoarded gold and capital sought refuge abroad. Today, investors are diversifying into various risk assets to escape the depreciation of fiat currencies. The dovish stance of the Federal Reserve further reinforces this trend.

The narrative of liquidity dominates the market, overshadowing fundamental concerns. Even if fiscal projections are seen as "fantasy," the market focuses on the abundance of short-term liquidity. This mirrors the "conundrum" of the 2000s, when despite the Federal Reserve's tightening, global capital flows kept long-term yields low.

Since 2009, the dollar has been experiencing a hidden depreciation, not against other currencies but against real assets like stocks, real estate, and cryptocurrencies. This parallels the 1970s, when the dollar's value shifted towards gold, oil, and real estate. Long-term bonds may now be following a similar path, experiencing a structural bear market as their "risk-free" label is eroded, potentially worse than the 1940s to 1950s.

The favorable outlook for the market hinges on whether long-term bond yields can remain stable. If yields stay low, abundant liquidity and dovish central banks will continue to support risk assets. However, structural distortions are laying the groundwork for future vulnerabilities, such as the unprecedented "mortgage lock-in" issue in the U.S. housing market, which hinders the effective transmission of policy easing to real estate, similar to Japan in the 1990s.

The real risk is not a typical economic recession but a repeat of the 1979 scenario—a sudden collapse in the long-term bond market, forcing policymakers to confront vulnerabilities and take drastic measures. Before this happens, structural themes like defense, nuclear energy, and artificial intelligence, as well as overlooked commodities like copper and oil, could become focal points driven by liquidity.