Top bond traders are starting to come to a new consensus about the direction of U.S. borrowing costs.
After weeks of turmoil at the end of 2016, an increasing number of them have come to believe there's a good chance that Treasury yields will fall before they rise.
BlackRock's Larry Fink, for example, noted that markets have probably gotten a bit ahead of themselves. It will most likely take until 2018 for Congress to put some of the new administration's policies in place. If that's the case, "there’s greater probability that the 10-year Treasury is below 2 percent, and we’ll have a market setback," Fink said at a conference this week.
Bianco Research's Jim Bianco agreed with Fink in a Bloomberg Radio interview. Meanwhile, DoubleLine analysts said 10-year U.S. bond yields would most likely decline to 2.25 percent before rising later in the year, according to a note reported by Bloomberg News.
This thesis makes sense, and it appears to be reflected in the muted moves in the nearly $14 trillion U.S. Treasury market over the past month. But once the market confidently starts down an expected path, it can be profoundly disrupted by unexpected obstacles, and a few assumptions that are undergirding sentiment right now could be upended.
First, the congealing forecast assumes that U.S. inflation will continue to chug along moderately. Currently, traders are still pricing in about a 2 percent rate over the next decade. While that's risen from 1.4 percent about a year ago, it's still historically low.
The concept of too much inflation still seems abstract to many investors because the U.S. has struggled to avoid deflation for the past eight years. But a change in trade policies could make it materially more expensive to buy everyday items in short order.
Second, there's a chance that the Federal Reserve will give meaningful guidance on when and how it plans to unwind its $4.5 trillion balance sheet. While some Fed members have discussed the issue, the two key members, Janet Yellen and Bill Dudley, haven't weighed in recently. If they were to even hint at starting to shrink the central bank's balance sheet, that could cause a spike in longer-term yields.
Third, several important political tests are on the horizon that could materially change the course of trading. Many Wall Street analysts have dismissed the threat of the far-right candidate Marine Le Pen winning this year's presidential election in France. But not so long ago these same analysts disregarded Donald Trump's chances of winning the U.S. election.
And Le Pen could directly influence the global bond market. She's proposed printing new francs to pay for welfare spending and to service the government's financial obligations. Le Pen has said that most holders of France's debt don't care what currency they get repaid in, but investors couldn't disagree more. The result of such a move could result in the biggest sovereign default in history and a rapid rise in yields around the world.
A reliable trajectory can be good for the bond market, but it also sets it up for greater shocks in the event of unexpected deviation. As it stands, the expectation is that Treasury bond yields will stay steady, or even dip a little, before turning higher. After a season of turmoil, that seems like a welcome break for the market, at least until it gets knocked off course again.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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