Many people are worried about the Federal Reserve, from President Donald Trump right down to millennials trying to buy homes.
The central bank has raised interest rates eight times since late 2015, marking a departure from the emergency measures it implemented in the wake of the financial crisis. Its benchmark for borrowing costs — the federal funds rate — now floats in a range of 2% to 2.25%, the highest since October 2008, right before Lehman Brothers imploded.
The Fed intends to continue raising rates gradually, but pockets of the economy, like housing, indicate that higher borrowing costs are starting to bite. The newly volatile stock market has signaled this as well.
Moving forward, the concern is that the Fed will end up overtightening policy, as it before many prior financial crises. But Goldman Sachs’ top market experts disagree with this view and have offered a trade recommendation that should benefit if expectations for the Fed are squashed.
The most recent so-called dot plot from Fed officials — which shows where the voting members predict interest rates will be in the short run — reflects that they expect to raise rates at their December meeting and three times in 2019. But the yield curve on forward rates, which plots traders’ expectations for interest rates, shows Wall Street doesn’t believe the Fed can pull this off.
“We think the front end of the US Treasury yield curve is currently underpricing future Fed hikes, and expect further flattening of the 2s30s US Treasury yield curve in the next few months,” Charles Himmelberg, the chief markets economist and head of global markets research at Goldman, said in a note.
“In our view, the risk that the Fed gets derailed from its intended path over the next 2-3 hikes is low.”
The trade idea from Goldman? “Enter a 2s30s UST flattener, target 25bp (1Q2019), stop loss: 60bp.”
If the market’s hunch turns out to be correct, it would be because of an external shock to the US economy that forces the Fed to slow its pace of rate hikes, Himmelberg said. This is one of the risks to his trade idea, and it could trigger a sell-off in short-term bonds that would lift yields.
Another risk to this trade that steepens yields is the deluge of Treasury bonds, Himmelberg said. Sales of the debt instruments this year are on pace to surpass levels last seen during the financial crisis as the government funds a budget shortfall ballooned by tax cuts.
However, Himmelberg’s trade idea lines up with history. Traders have typically underestimated the degree of Fed tightening, and he doesn’t see why this time would be different.