Transformation in the U.S. bond market: "Inflation concerns" outweigh "rate cut expectations"

Amid a violent sell-off in the global bond market triggered by soaring energy prices and inflation fears, Goldman Sachs warned in its latest issue of "Global Interest Rate Trader" report that the market has mispriced. In the report, Goldman Sachs' interest rate strategy team painted a picture of a global bond market dominated unilaterally by inflation fears: influenced by geopolitical tensions in the Middle East and energy supply shocks, major central banks around the world collectively released hawkish signals, leading to a sharp rise in front-end interest rates, with "inflation concerns" completely dominating the current trading logic. However, the team believes that the continuous selling of terminal rates by the market is already "inconsistent with the nature of the shock." While investors are feverishly pricing in central bank hawkish expectations, they are systematically and seriously underestimating the "left tail risk" - the risk that high energy costs will eventually lead to a collapse in total demand and a sharp slowdown in economic growth. Goldman Sachs deliberately added the word "For Now" in the title of the report. The core judgment is that inflation dominance is just a temporary frenzy, and economic growth concerns will eventually take over the market, stabilizing forward rates and flattening the yield curve. However, investors need to be highly cautious about arbitrage trading until the situation cools down or there are clear signs of deterioration in the labor market. Inflation panic dominates the global scene: central banks around the world collectively turn hawkish, with a sharp turn from rate cuts to rate hikes In the past week, "inflation vigilance" has become a common theme among central banks around the world, with an unusually high density of hawkish signals. The March FOMC meeting continued the hawkish tone. Goldman Sachs pointed out that inflation risk has become the absolute focus of the interest rate market, despite the increase in growth risk, the initial economic fundamentals are still sound, and market reactions are orderly, limiting the space for growth concerns to outweigh inflation concerns. To tilt the balance towards growth, first, the risks at the tail end of growth need to become "sufficiently clear and persistent" - either the stock market needs to show a more sustained negative reaction to rising oil prices, or the labor market needs to show a clearer signal of deteriorating. In the environment of supply shocks, the diversification benefits of nominal bonds have already been weakened, which means that the threshold for the market to shift towards a growth narrative is higher. Repricing in Europe is particularly severe. The report shows that the front-end interest rates in Europe are currently priced at nearly three rate hikes, reflecting deep concerns about high and stickily priced commodities (damage to energy infrastructure may limit inflation relief). Goldman Sachs pointed out that major central banks such as the European Central Bank are showing an open attitude towards near-term rate hikes, rather than being patient in the face of potential temporary shocks. Current pricing is approaching the upper limit of Goldman Sachs' economist risk scenarios. Considering that every rise in energy prices will tighten financial conditions and weaken growth expectations, it is becoming increasingly difficult for the market to "outpace hawkishness." The most striking case is the UK. After the Bank of England meeting, the UK's 2-year bond yield rose by more in the 20-minute window before and after the announcement than any reaction to a policy meeting during the 2021-2024 tightening cycle. Based on this, Goldman Sachs economists announced that they no longer expect the Bank of England to cut rates this year and significantly raised their forecast for the 10-year UK gilt yield at the end of 2026 to 4.40% (up from 4.25%), while compressing their 2-year/10-year yield curve forecast to 50 basis points. As of March 20th, the market is even pricing in nearly 90 basis points of rate hikes by 2026, which Goldman Sachs believes is overpriced, but they admit that a clear path of decline in commodities is needed to ease this. Core judgment: Terminal rate selling is "inconsistent with the nature of the shock," left tail risk is severely underestimated At a time when the market is unilaterally dominated by an inflation narrative, Goldman Sachs believes that the continuous selling of terminal rate pricing is inconsistent with the nature of this shock. Evidence shows that neither long-term inflation expectations nor long-term risk premiums have shown that the market is worried that the Fed's policy response will be "overly dovish." In other words, the market is pricing in rate hikes at the front end, but is not reflecting fears of central banks allowing inflation at the long end. If the market truly believed that inflation would spiral out of control, long-term risk premiums should rise significantly - but this has not been the case. This suggests that the selling of terminal rates is more reflective of panicked emotions rather than fundamental logic. More importantly, Goldman believes that the "left tail" risk - the scenario where damage to total demand begins to outweigh inflation concerns - is severely underpriced. The report points out that although the reset amplitude of interest rate volatility caused by hawkish policy risks is comparable to that around "D-day", the volatility curve no longer looks cheap relative to macro fundamentals, but the skewness at the front end has embedded significant changes in the policy response function, which is an overcorrection. At the strategic level, Goldman therefore suggests fading USD risk reversals through options to bet against the recent hawkish pricing changes, rather than directly selling volatility - because the former provides better protection in a scenario where growth turns downward. At the same time, Goldman remains cautious about carry strategies (including selling volatility and going long on spreads): although valuations have improved, these strategies will face severe tests once the "left tail" of growth opens up. Outlook: Growth concerns will eventually take over, but the turning point is still awaited Goldman's year-end outlook for 10-year yields in major markets is generally lower than current levels and forward pricing, reflecting its mid-term judgment that "inflation dominance will eventually give way to growth concerns." Specifically: US 10-year Treasury yield is forecasted to be 4.10% at the year-end (currently around 4.37%, lower by 43 basis points in the future); UK Gilt 4.40% (lower by 75 basis points in the future); Japan JGB 2.00% (currently 2.28%); German Bund 3.00% (currently 3.04%). At the same time, Goldman's position and sentiment monitoring show that the current readings of US option implied positions index (OPI), fund positions index (FPI), and data reaction index (DRI) are all around zero - indicating no clear bias towards long or short in the market. This neutral state itself implies that once the macro narrative shifts, there is ample room for the market to move significantly in either direction. Goldman's advice is clear: maintain a light directional exposure with limited risk participation. Until clear trigger signals are provided by geopolitical situations or economic data, the bond market's inflation fears may continue for some time - but the contradiction between terminal rates and the nature of supply shocks means that this state is not permanent. Once evidence of a slowdown in growth accumulates to a sufficient extent, the market's reverse correction in interest rates may come fast and furious. This article is based on "Wall Street News" and the author is Gao Zhimou, GMTEight editor: Chen Siyu.