Goldman Warns Not To Use Expensive Bonds To Hedge Against Crashing Stocks

Government bonds failed to provide a solid hedge against falling stocks this summer. Goldman Sachs believes that rising interest rates will boost term premiums. Treasury bond ETFs have outperformed the S&P 500 over the past year.

In a new report, Goldman Sachs analyst Francesco Garzarelli explains why the firm believes that government bonds remain too expensive to serve as effective hedges against a falling stock market. For now, traders should look elsewhere for return until the U.S. Treasury curve steepens over the next several months.

The Price Must Be Right

While Treasury bonds have historically been good hedges against a falling stock market, Garzarelli believes that high bond prices were the reason why bonds served as a poor hedge during the S&P 500 pullback this summer. He believes that there is not enough incentive to prefer the volatility of bonds over the relative safety of cash at recent prices.

Even factoring in the (relatively small) downgrade our economies recently announced to 2016 nominal GDP growth, intermediate maturity Treasuries still look stretched on current valuations, Garzarelli explains.

Fed Tightening Will Boost Term Premium

Expectations of a September Fed rate hike have continued to build on Wall Street in recent months, but Goldman is still calling for a rate hike no sooner than December.

Term premiums are currently historically low. However, Garzarelli notes that term premiums tend to rise in the six months following the Feds first rate hike of a new tightening cycle.

Outlook

Goldman is calling for the 2-to-10-year U.S. Treasury curve slope to steepen to about 1.75 percent within the next three months. In addition, the firm believes that consensus inflation expectations in both the U.S. and in Europe are too low.

Shares of the iShares Barclays 1-3 Year Treasury Bond ETF (NYSE:SHY), the iShares Barclays 7-10 Year Treasury ETF (NYSE:IEF) and the iShares Barclays 20+ Year Treasury Bond ETF (NYSE:TLT) have all generated positive returns over the past year while the S&P 500 has fallen 2.5 percent.

Disclosure: the author holds no positions in the stocks mentioned.