Goldman Sachs Warns: The Market May Not Be Ready for Fed Rate Hike in December

Goldman Sachs still views a rate hike in December as the baseline scenario, but the market is pricing in about a 90% chance of a hike, and the difficulty of reintroducing a full 25 basis points is increasing.

Written by: Li Jia, Wall Street Insights

U.S. Treasury yields have quickly retreated from their highs, with the two forces that previously pushed rates up—AI investment frenzy and energy price shocks—beginning to diverge. Goldman Sachs warns that the market's judgment on the Federal Reserve's policy path faces greater uncertainty, and whether or not to raise rates in December could trigger a new reassessment of risks.

On Thursday, the yield on the 10-year U.S. Treasury fell by 17 basis points in a single day, marking the largest single-day drop since March 2023, and fell back below 5%. Cosimo Codacci-Pisanelli, a strategist in Goldman Sachs' Fixed Income, Currency, and Commodities division, pointed out in a recent report that the very AI trades that previously pushed rates higher are now driving yields lower.

As AI stocks face sell-offs, funds are flowing back into long-term U.S. Treasuries, reversing the correlation between stocks and bonds, with bonds once again becoming a tool for stock investors to hedge against risks. However, this does not mean that the risk of rising rates has been eliminated: the supply pressure from AI capital expenditures and debt financing still exists, and the trends in energy prices and inflation make the Fed's next steps harder to predict.

Goldman Sachs still considers a rate hike in December as the baseline scenario but believes the market will find it difficult to easily reintroduce a full 25 basis points hike. Meanwhile, the interactions between AI growth prospects, energy shocks, and bond supply and demand are changing, and the market must guard against deteriorating growth expectations while not ignoring the tightening risks posed by persistently high inflation.

AI Trading Reverses, U.S. Treasuries Regain Safe-Haven Demand

Codacci-Pisanelli attributes the recent decline in U.S. Treasury yields to three factors: high rates beginning to suppress AI-related assets; an increase in tail risks of a significant slowdown in AI-driven growth; and a change in the correlation between stocks and bonds, with long-term U.S. Treasuries once again playing a role in hedging stock risks.

This change contrasts with the earlier situation this month when U.S. inflation data was hot, and both stocks and bonds fell in sync. Nomura Securities strategist Charlie McElligott previously pointed out that as the market reassesses the growth prospects driven by AI, bonds have once again become a hedging tool in portfolios.

Meanwhile, credit spreads related to AI have widened to their widest levels of the year, with financing risks receiving more attention. Previously, Goldman Sachs warned that the credit market might remain calm until the wave of debt financing driven by AI capital expenditures restarts. Now, the pullback in AI stocks and the widening of credit spreads are testing this growth model that relies on continuous financing and capital expenditure expansion.

However, Goldman Sachs cautions that short-term changes in fund flows are insufficient to reverse the structural supply and demand pressures in the U.S. Treasury market. AI capital expenditures are expected to reach about $1.6 trillion by 2027, with the proportion of debt financing also rising. As long as the AI investment outlook does not collapse significantly, the related financing demand may still translate into supply pressure on bonds. Outflows from AI stocks can temporarily support U.S. Treasuries, but sustained buying will still require a broader stock market decline or further deterioration in growth expectations.

December Rate Hike Remains Goldman Sachs' Baseline Scenario, but Market Pricing Struggles to Keep Up

Before the Federal Reserve's October meeting, despite hot inflation data, market expectations for a rate hike this month have significantly cooled. Goldman Sachs strategist Codacci-Pisanelli pointed out that inflation performance provides a basis for a rate hike, but Fed Chair Waller previously declined to provide clear guidance on subsequent rate decisions, leading the market to gradually lean towards the Fed pausing rate hikes in October and leaving policy adjustments until December.

Goldman Sachs still views a rate hike in December as the baseline scenario but believes the market will find it difficult to fully reintroduce a 25 basis point hike. As stock market volatility increases, investors need to weigh the further impact of rate hikes on risk assets and the risks of potential deterioration in economic and financial conditions.

As of October 23, Goldman Sachs data shows that the market is pricing in about a 90% chance of a rate hike in December, with pricing for cumulative hikes until September 2027 at about 2.7 times. Although rate hikes have been reflected in prices to a considerable extent, there remains significant uncertainty regarding the future policy path. Goldman Sachs' judgment is that how the Fed proceeds next is still extremely difficult to predict.

This also means that a decline in U.S. Treasury yields does not equate to rates having peaked. If a slowdown in AI investment drags down growth expectations, U.S. Treasuries may continue to benefit from safe-haven demand; however, if energy prices remain high and inflation does not decrease, policy rates and bond supply may still push yields higher.

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