Why 2017 May Be Another Volatile Year for the World's Biggest Bond Market

Will 10-year U.S. Treasuries slump to 1.35 percent by the end of 2017?
Photographer: Andrew Harrer/Bloomberg

Gear up for another year of two halves.

As 10-year Treasury yields climb above 2.5 percent for the first time since October 2014, analysts warn those yields could stage a sharp reversal next year as economic headwinds kick in.

HSBC Holdings Plc, for example, reckons 2017 will bear witness to two starkly different trends in the U.S. rate market, challenging conventional forecasts that plot a linear path for yields based on a single scenario for the U.S. economy. The bank warned last month that 10-year U.S. Treasuries will remain largely range-bound in the coming months — in the region of 2.5 percent by the end of first quarter of 2017 — before tumbling to 1.35 percent by year-end, as tighter monetary conditions pave the way for slowing U.S. growth.

That's a far cry from the median analyst forecast for the fourth quarter of 2017 of 2.66 percent, and implied projections in the forward market of 2.73 percent.

In a report on Friday, the analysts led by Lawrence Dyer, defended their outlier view, amid pushback from clients.

We believe the high level of debt, concentrated distribution of wealth and income, and changing demographics for the U.S. and the rest of the world mean the risks are biased towards lower yields in 2017. The recent reflation trade has been driven by expectations of a fiscal boost after the election. This view is likely to dominate the longer-run economic headwinds in the near term.

They cite the prospect of a sharp shift in the market narrative next year that would push U.S. bond prices lower, an effective mirroring of this year's volatility that saw yields fall below 1.36 percent in the summer, before reversing course in the last quarter. 

Our forecast process is unconventional; it gives significant weight to the risks to the economic outlook, rather than a central base case scenario. In contrast, the more conventional forecast process that determines the consensus view on yields assumes a single scenario for the economy. Given the way markets have performed in recent years, we do not see this conventional forecasting process as being well equipped to measure or manage potential market risks.

In other words, HSBC is pouring cold water on conventional attempts to map out the outlook for 10-year Treasuries, which serve as the effective risk-free benchmark for trillions of dollars of fixed-income assets and the bellwether for investor sentiment about the outlook for the global economy and the discount rate for U.S. equities. 

In the wake of the Trump's victory, market pricing has shifted materially in favor of the Federal Reserve's implied path for rates, with forward markets now projecting two hikes in 2017, in line with the median view of Fed officials. According to HSBC, that suggests officials lack an incentive to lay out more hawkish guidance — another pressure point, in addition to the Fed's projected monetary offset, in favor of lower yields.

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The bank's word of caution finds support from Martin Enlund, chief currency strategist at Nordea Markets. In a note to clients on Monday, he argues tighter financial conditions, the re-emergence of short positioning, and the waning impact of higher energy prices on inflationary pressures will conspire to constrain U.S. growth by the second quarter of 2017, a headwind for yields.  

"A lot of good news should be in the price by now, and while Trump could boost fiscal policy – that’s probably more of a theme for 2018 than for 2017."

He concludes: "Fixed income positioning has also shifted, and U.S. data surprises have been positive recently – suggesting that the market is now likely becoming very sensitive to any negative surprises. In short, “everyone” was long U.S. fixed income in August, now it’s the opposite."

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