This is where the Trump interest rate trade goes now, bond traders say

Published Tue, Nov 22 20165:00 AM ESTUpdated Tue, Nov 22 20169:48 AM EST

Patti Domm @in/patti-domm-9224884/@pattidomm

After ripping higher on the Trump trade, longer-term interest rates may be about to calm down for a while. The 10-year Treasury yield is close to its high of the year, and while it could move slightly up from here, it's not expected to post a dramatic increase, a number of strategists say. Postelection, the yield moved quickly to 2.30 percent, and now has been consolidating in a zone between 2.30 and 2.36 percent. The immediate move higher shook the rates world and sent home mortgages above the psychological 4 percent. The 10-year's current level is important because the yield is in an area where it was at the end of 2015, when it looked like the Fed could raise rates four times in 2016, and the outlook for the economy was fairly good. Since then, all kinds of concerns for the economy intervened, and the Fed has a final chance to raise rates once this year, when it meets in December. Rick Rieder, BlackRock's chief investment officer and co-head of global fixed income, said he believes the postelection move is nearly over. "We're pretty close to fair value now and I think momentum could certainly pull you back to 2.50," said Rieder. But he expects the 10-year to trade in a range between 2 and 2.50 percent this year, moving to 2.75 percent in 2017. Donald Trump's surprise White House victory changed everything for the markets. Stocks rallied and the dollar surged as yields moved higher. The promise of a major fiscal stimulus package and tax cuts spurred expectations that the economy would grow faster, bringing with it rising inflation and higher interest rates. "We go from a period of secular stagnation to one where we start thinking about business investment and other stimulus from other areas on the fiscal side. The 2.30 area represents, to me, a borderline, below which we are in secular stagnation mode and above which we're in an area where fundamentals begin to matter more," said Jim Caron, fixed income portfolio manager at Morgan Stanley Investment Management. Caron expects yields to reach 2.50 to 2.65 percent this year, depending on what the Fed signals about rates when it meets in December. It is expected to hike 25 basis points at the Dec. 14 meeting, its second rate hike in 10 years. "I think we're at a cuspy level right now. If I thought of a trade that would hurt the most people it would probably be higher yields, rather than lower yields," he said. Caron said he expects to see slower flows into Treasurys, as investors react to outflows. "If I look at it today, I would say the risk is more to the upside than the downside. People are still holding out, saying these levels are so high. Look at the two-year auction. It didn't go so well. It was a little bit weak," said Caron. The Treasury auctioned $26 billion two-year notes Monday, at a yield of 1.085 percent, the highest level in seven years. But some strategists say there is a natural cap on rates, and the rate rise could ultimately slow itself down. For instance, the dollar rises with rates, and the higher greenback could become a negative for the U.S. economy. The rising yields also attract buyers, like insurance companies and pensions that need to hold longer duration bonds and have been starved for yield. Yields move inversely to price. Some strategists see yields moving to even lower levels by year end, and then rising again next year. "I think the market is calming down and it will be a grind lower in yields, as the realities of what the incoming administration can and cannot offer get priced in. We are in the honeymoon period. And the market is still in the honeymoon suite at the Trump Tower. I think we're trying to see what the incoming administration looks like and we're reading the tea leaves as far as appointments go and other official communiques," said Ian Lyngen, head of rate strategy at BMO. "We're going to need to continue to get these anecdotes and bits of information." Lyngen said the 10-year yield could slide back to 2.15 percent this year. The line in the sand — 2.30 to 2.37 — is significant to chartists, though strategists expect it to be an area on the 10-year that gets tested again. "We were at 1.40 in the summer. That's nearly a 100 basis points sell-off. Those kind of moves don't happen that often. Whenever you have a move that's 90 basis points in 90-plus days, that usually ends up retracing half of it, but because it's a new regime and the market is skittish, I doubt it retraces half," said George Goncalves, head of rate strategy at Nomura. Goncalves said the retracement could be 15 to 20 basis points and it could last into the early part of next week. "Then we go into the [nonfarm payrolls] at a much more stable level of 2.20 to 2.25. I think that's what's going to happen," he said. "I think we're due for a retracement sort of rally, short lived in nature but probably worth 15 to 20 basis points." Goncalves expects the 10-year to be closer to 2.20 than 2.50 percent at year end. "The market valuation looks relatively cheap, but considering no one wants to look at historical patterns, they think it's a new world order. It's challenging to get people to look at the market which just went unhinged. We did over shoot by about 20 basis points," he said. Caron said it is possible yields will unhinge again if selling starts to snowball, and the market could behave like it did during the 2013 "taper tantrum," when bonds sold off in response to Fed policy change. Caron believes there's just a 25 percent chance of that, but he also believes yields have been too low. "If you believe there has been a fundamental shift in the market with a Trump presidency, which means it's going to be more about business investment, capex, then yields should be higher, north of 2.75 percent," said Caron. The Treasury auctions $34 billion five-year notes Tuesday, and that will be watched to see what type of buyers show up. In the two-year auction Monday, dealers took an unusually high 51 percent of the supply, up from about 42 percent. Lack of participation at auctions is one thing that strategists say could drive rates higher, particularly if at some point, the fiscal stimulus plan requires much more debt. But strategists say there are balancing factors that could keep rates from streaking higher. That stronger dollar, for one, could start to hurt equities and slow the emerging world. That might send buyers back into bonds. "There's a lot of things still out ahead of us. We're going to wake up at some point and realize there's an Italian referendum. There are still things that could upset the apple cart," said Goncalves. He said the Fed should hike Dec. 14, but not change from its relatively dovish stance. Currently, it is forecasting two more hikes next year. Ahead of that Dec. 14 Fed decision, there is the November employment report on Dec. 2 and the Italian constitutional referendum on Dec. 4. "Once we're above 2.50 and we're approaching 3 [percent], then housing is going to stall," Goncalves said. "When does rates actually become the pin that pricks all valuation bubbles everywhere? Be careful what we wish for. That would be too much too soon." Goncalves said he expects 2.75 to 2.80 to be the high side. "If we do break 2.75 convincingly, then we have entered a new regime. If you break that convincingly then we've really killed the 35-year bond market rally," he said.

Donald Trump speaks during a rally at West Star Aviation in Grand Junction, Colorado.

Mandel Ngan | AFP | Getty Images

After ripping higher on the Trump trade, longer-term interest rates may be about to calm down for a while.

The yield is close to its high of the year, and while it could move slightly up from here, it's not expected to post a dramatic increase, a number of strategists say.

Postelection, the yield moved quickly to 2.30 percent, and now has been consolidating in a zone between 2.30 and 2.36 percent. The immediate move higher shook the rates world and sent home mortgages above the psychological 4 percent.