Is the buying opportunity here after yields surge? Goldman Sachs, Morgan Stanley, and other Wall Street giants optimistic about U.S. Treasury rebound prospects

According to Zhitong Finance APP, following several weeks of sell-offs that have driven U.S. Treasury yields to multi-year highs, Wall Street strategists are reassessing the investment value of U.S. treasuries. Institutions such as Goldman Sachs, Morgan Stanley, and Citigroup believe that as U.S. Treasury yields have surged, the attractiveness of bond valuations is increasing. However, there are still significant differences among major institutions regarding the future interest rate path of the Federal Reserve and the timing of a potential bond rebound.

Currently, the yield on the U.S. 10-year Treasury stands at about 5.24%, having previously risen to its highest level in decades, though robust demand at last week’s Treasury auction caused yields to pull back. In contrast, short-term Treasury yields have remained relatively stable, with the two-year Treasury yield hovering around 4.8%. Due to the holiday, the U.S. bond market was closed on Monday.

In a report released last Friday, a team led by Goldman Sachs strategist William Marshall pointed out that although the view that G10 government bond yields would stabilize or decline based on valuation has been increasingly challenged, long-term forward rates in most major markets are now significantly higher than reasonable levels, and several factors are further reinforcing the current view that bond duration is attractive.

Goldman Sachs believes that signs of stress are emerging in credit markets, and improvements in investor positioning and market technical risks could create conditions for a U.S. Treasury rebound. The bank noted that convexity risk related to mortgage-backed securities is now close to zero, and asset managers’ allocations toward benchmark bonds remain underweight, suggesting that the technical pressures that previously exacerbated Treasury sell-offs are easing. Goldman Sachs recommends positioning in the interest rate swap market to capture the potential return in the 10-year segment relative to the 5-year and 30-year sectors.

Citigroup, on the other hand, is more favorable towards short-term U.S. Treasuries. In an October 9 report, strategists including Jason Williams said that as inflation slows and wage growth weakens, the Federal Reserve is unlikely to raise rates to 2023 highs.

Citigroup expects the Fed to keep rates unchanged at this month's monetary policy meeting and sees 2- to 3-year U.S. Treasuries as the more appropriate allocation area for now. The bank forecasts a month-on-month increase of 0.18% in the U.S. core Consumer Price Index (CPI). Even if the core CPI rises by 0.3% month-on-month, Citigroup still believes this would not be enough for the Fed to hike rates in October.

Morgan Stanley also maintains that Treasury yields are now attractive. A team led by strategist Matthew Hornbach noted that unless investors are expecting a U.S. nominal GDP annual compounded growth rate of 5.7% over the next ten years and a core Personal Consumption Expenditures (PCE) Price Index annual compounded increase of over 2.5%, current U.S. Treasury yields already present investment value.

Morgan Stanley stated that economists expect U.S. nominal GDP to grow at about 4.5% next year, which suggests that the 10-year Treasury yield could be lower than its current level of roughly 5.25%. Further calculations show that if nominal economic growth in the U.S. over the next decade stays between 4% and 5%, with core PCE inflation around 2%, then based on historical experiences before the implementation of quantitative easing policies, the 10-year Treasury yield could fall back to the 3.5% to 4.5% range.

However, Morgan Stanley recommends that investors wait until after this month's Federal Reserve policy meeting and the U.S. mid-term elections before considering an entry.

Mitsubishi UFJ Financial Group also believes that Treasury valuations have entered a highly attractive range. The bank pointed out that recent strong demand at Treasury auctions indicates the previous surge in yields has been enough to lure value investors back into the market. Meanwhile, the group noted that the U.S. mid-term elections could become a key catalyst influencing Treasury market movements, as different outcomes may alter future fiscal spending and policy outlooks, thereby impacting the bond market.

However, not all Wall Street institutions are optimistic about a Treasury rebound.

Strategists at Bank of America, including Mark Cabana, believe the market is underestimating the chances of another Fed rate hike this month. Currently, interest rate swap markets imply a probability of only 19% for a rate hike in October, which the bank believes is too low. BofA pointed out that if U.S. economic data remains robust, the Fed may face a dilemma: either raise rates further to curb inflation or tolerate a continued surge in bond yields.

Strategists at Barclays, such as Anshul Pradhan, emphasized that while higher yields increase the investment attractiveness of bonds, this does not mean investors are immune to the risk of yields rising further. According to the bank, with the 10-year Treasury yield at around 5.25%, the implied term premium is about 1.3 to 1.5 percentage points. This indicates that holders of long-term bonds are receiving higher risk compensation, but it does not mean yields have necessarily peaked.

UBS also maintains a tactically neutral stance on Treasury duration. The bank believes current yields are above reasonable valuation levels, but given robust U.S. economic activity and persistent geopolitical risks that may keep energy prices elevated, long-term Treasury yields still face upward pressure.

Wells Fargo noted that there are some positive signals in the Treasury market, including the 10-year yield retreating from its high of 5.35%, strong demand in recent Treasury auctions, and a decrease in interest rate volatility from elevated levels. However, the bank believes that to drive a sustained decline in long-term Treasury yields, the market still needs a clear catalyst in the form of significantly weaker economic growth.

U.S. inflation data to be released this week will be key in determining whether Treasuries can continue their rebound. Most strategists currently expect the U.S. core CPI to rise about 0.2% month-on-month, suggesting inflationary pressures may have eased somewhat. But if the actual data exceeds expectations, the market may once again increase bets on additional Fed rate hikes, potentially pushing Treasury yields higher again.