Goldman Sachs warns: Whether the Federal Reserve raises rates in December or not, the market may not be prepared

U.S. Treasury yields have quickly retreated from their highs, as the forces that previously drove rates higher—AI investment mania and the energy price shock—are now diverging. Goldman Sachs warns that the market's assessment of the Federal Reserve's policy path is facing greater uncertainty, and whether or not there is a rate hike in December could trigger a new wave of risk repricing.

On Thursday, the 10-year Treasury yield fell by 17 basis points in a single day, marking the largest one-day drop since March 2023, once again breaking below 5%. Cosimo Codacci-Pisanelli, strategist in Goldman Sachs' Fixed Income, Currency, and Commodities division, pointed out in the latest report that it is precisely the AI trades that previously helped push rates higher that are now driving the retreat in yields.

As AI-related stocks faced sell-offs, capital flowed back into long-duration Treasuries, reversing the previous correlation between stocks and bonds, and bonds have once again become a hedge for equity investors. However, this does not mean the risk of rising rates has been eliminated: the supply pressure on Treasuries from AI-driven capital expenditure and debt financing still exists, while energy prices and inflation trends also make the Fed's next move harder to predict.

Goldman Sachs still sees a December rate hike as its base case, but believes it will be difficult for the market to fully reprice a 25-basis-point hike. Meanwhile, the interplay between AI growth prospects, energy shocks, and bond supply and demand is evolving; the market must guard against both deteriorating growth expectations and the ongoing risk of tightening from persistently high inflation.

AI Trades Reverse, Treasuries Regain Safe-Haven Bid

Codacci-Pisanelli attributes the recent decline in Treasury yields to three factors: high interest rates beginning to weigh on AI-related assets; growing tail risk of a significant slowdown in AI-driven growth; and a shift in stock-bond correlation, with long-duration Treasuries once again serving as a hedge for equity risk.

This is in contrast to the situation earlier this month when U.S. inflation data were hotter than expected and both stocks and bonds fell simultaneously. Nomura strategist Charlie McElligott previously noted that as the market reassesses AI-driven growth prospects, bonds have again become a portfolio hedging tool.

At the same time, AI-related credit spreads have widened to their highest levels of the year, and financing risks are drawing more attention. Previously, Goldman Sachs warned that the credit market could remain calm until a new wave of debt financing fueled by AI capital expenditure reignites. Now, the pullback in AI stocks and the widening of credit spreads are testing this growth model, which relies on ongoing financing and capital expansion.

However, Goldman Sachs reminds that short-term shifts in capital flows are not enough to reverse the structural supply-demand pressures in the Treasury market. AI capital expenditures are expected to reach about $1.6 trillion by 2027, with an increasing share financed by debt. As long as the AI investment outlook remains intact, related financing demand could continue to translate into supply pressure for Treasuries. Outflows from AI stocks may temporarily support Treasuries, but sustained buying will require a broader equities selloff or a further deterioration in growth expectations.

Goldman's Base Case Remains a December Rate Hike, but Market Pricing Lags

Ahead of the Fed's October meeting, despite hotter-than-expected inflation data, market expectations for a hike this month had cooled significantly. Goldman strategist Codacci-Pisanelli pointed out that while inflation data provide grounds for a hike, Fed Chair Powell previously refused to give clear guidance on future rate decisions, and the market has gradually leaned toward the Fed pausing in October, leaving any policy change for December.

Goldman Sachs still sees a December rate hike as the base case, but believes it's difficult for the market to fully reprice a 25-basis-point hike. As equity volatility rises, investors need to weigh the additional impact of rate hikes on risk assets, as well as the potential for economic and financial conditions to further deteriorate.

As of October 23, Goldman Sachs data showed that the market-implied probability of a December rate hike was about 90%, with a cumulative pricing of around 2.7 hikes by September 2027. Although hikes are largely reflected in current prices, there is still significant uncertainty regarding the future policy path. Goldman's assessment is that the Fed's next move remains highly unpredictable.

This also means that the decline in Treasury yields does not equate to interest rates having peaked. If a slowdown in AI investment drags down growth expectations, Treasuries could continue to benefit from safe-haven demand; but if energy prices remain high and inflation fails to ease, policy rates and bond supply could still drive yields higher.