Goldman Sachs is warning that Fed Chair Walsh's decision to eliminate forward guidance has obscured the policy framework, making it harder to rebuild credibility and potentially accelerating its erosion. If economic data does not clearly soften before September, the market may force the Federal Reserve to raise interest rates again.
Meanwhile, persistent global fiscal expansion is driving up term premiums, with the speed of momentum-driven deleveraging rivaling that seen during the COVID-19 shock. The Federal Reserve has held steady on rates, but market turmoil triggered by a single press conference is shaking investor confidence in its policy framework.
The Fed kept rates unchanged at its July meeting, but the real market mover wasn't the decision itself; it was Chair Walsh's remarks during the press conference. Goldman Sachs' head of trading, Rich Privorotsky, noted that Walsh failed to clearly articulate a reaction function when questioned about the trade-off between inflation and employment, sharply escalating market doubts about the Fed's policy logic. The 30-year Treasury yield consequently surged to a new high, significantly steepening the yield curve.
Goldman Sachs warns this situation could backfire: if the Fed removes forward guidance while simultaneously obscuring its policy framework, its credibility may not only remain unrepaired but could suffer further damage. More critically, the runaway movement in long-end yields could force the Fed to act again—unless economic data clearly turns weak before September, the market may pressure the Fed to raise rates to re-anchor the long end and restore credibility.
Press conference becomes the focus, missing reaction function draws scrutiny
According to Goldman Sachs' Rich Privorotsky, Chair Walsh's core goal since taking over the Fed has been to rebuild credibility lost after years of failing to achieve its 2% inflation target, primarily by eliminating forward guidance. However, removing guidance doesn't mean it's acceptable to avoid framework transparency. At the press conference, when pressed on how to trade off between inflation and employment, Walsh failed to provide a clear policy reaction function. When asked about the basis for its inflation judgment, he stated that the committee considers a broader range of indicators but did not specify which indicators carry the most weight or how they are weighted.
Rich Privorotsky pointed out that if the Fed removes forward guidance while simultaneously masking its policy methodology, the result for credibility could be the opposite of the intention—not improvement, but deterioration.
Long-end yields lose anchor, potentially forcing another rate hike
Market confusion over the Fed's reaction function is directly reflected in the violent movements of long-end yields. The 30-year Treasury yield broke through to a new high after the meeting, accompanied by a significant steepening of the yield curve, indicating growing market concern about long-term inflation and fiscal prospects. Goldman Sachs believes this trend carries significant policy implications.
Unless economic data shows a clear and broad-based weakening before September, the market may actively "demand" the Fed to raise rates again in order to re-anchor the long end and restore policy credibility. The combination of low front-end rates and high long-end rates is particularly unfavorable for small-cap stocks and other long-duration assets.
Global fiscal expansion intensifies long-end pressure
The concern over long-end yields does not exist in isolation but is embedded within a broader global fiscal backdrop. Goldman Sachs notes that in Japan, Takaichi is pushing for a consumption tax cut. In the UK, policy discussions have shifted from "whether to increase defense spending" to "how to pay for it." Fiscal deficits across developed markets are continuing to widen, showing no signs of normalization. Since the COVID-19 pandemic, the fiscal stance of major economies has moved in only one direction and has never normalized.
This structural characteristic means that term premiums will continue to rise, inflation will be more sticky, and nominal interest rates will remain structurally higher for longer.
Risk assets under pressure, market deleveraging continues
At the market level, Goldman Sachs paints a concerning picture. Stocks are being sold off, the U.S. dollar is weakening, and risk assets are under broad pressure, driven primarily by doubts about the Fed's reaction function. Simultaneously, the market is undergoing a sharp deleveraging process. Goldman Sachs points out that the current drawdown in momentum strategies has exceeded 2.5 standard deviations from the 20-day moving average, a pace of deleveraging so fast that comparable instances are almost only found during the COVID-19 period.
However, the nature of the two events differs: the pandemic period involved a passive sell-off due to market dysfunction, whereas this appears to be an active purge following excessive concentrated positions and high leverage accumulation. Historical data suggests that from a similar oversold level, the forward-looking returns over the next 15 years are typically flat to positive. But Goldman Sachs believes that for a recovery with a better Sharpe ratio, the key is a convergence of realized volatility relative to the S&P 500. Until then, momentum strategy movements will be more volatile and range-bound, rather than exhibiting an explosive rebound.
On the fundamental side, Goldman Sachs thinks corporate earnings still provide support for related trades, but the market's pricing logic is shifting. Investors are increasingly less willing to simply pay for AI capital expenditure and are more inclined to reward companies that can demonstrate AI monetization results. Goldman Sachs believes this distinction will become crucial in the upcoming earnings seasons.
Comments