An $800 billion disconnect between the Fed and Treasury is ballooning in the bond market: Wells Fargo

Just as the Federal Reserve pares back its bond holdings, the U.S. government is bringing more to market. That could have a major impact on bond yields, says one Wells Fargo strategist.

"The government bond supply, which is surging now, is really the big difference maker," Michael Schumacher, head of interest rate strategy at Wells Fargo, told CNBC's "Futures Now" on Tuesday. "At the same time the Fed is shrinking its portfolio — we heard this from the new chair Mr. [Jerome] Powell last week — the Treasury is issuing bond after bond after bond."

The difference between Treasury supply and Fed buying is a "disconnect" that could balloon to $800 billion this year, estimates Schumacher, pushing yields significantly higher.

Wells Fargo expects the yield on the 10-year Treasury note to hit 3.20 percent by the end of the year, around 40 basis points higher than current levels. Yields have not been that high since May 2011. The 10-year has not even crossed the 3 percent threshold since January 2014.

Supply levels have been on bond traders' minds this week. The U.S. Treasury will put up for auction a record $294 billion in new debt before the holiday weekend as it covers rising federal government spending and lower tax revenues. President Donald Trump signed a $1.3 trillion budget on Friday.

The Fed, a big purchaser of bonds, began to unload its holdings last October. Progress in reducing its Fed's balance sheet will likely not change unless its outlook sees a "very significant and unexpected weakening," Fed Chairman Powell reaffirmed in his first press conference last week.

"Who is going to buy the bonds? We keep searching around and there haven't been, frankly, many takers," said Schumacher. "The U.S. Treasury right now is scrambling a little bit, and it's that big glut you've got coming out of the market that really should push rates up."

The potential for a trade war between U.S. and China is another big risk to the bond market, says Schumacher. Bond rates could go in either direction depending on how new developments play out.

"If it's not really a trade war, then it's more a skirmish. Then you can say it's inflationary, rates probably go up a little bit," said Schumacher. "If it really deteriorates into an all-out war then it's probably an economy killer and rates drop. It's kind of a nuanced thing."

The yield on the 10-year Treasury is hovering close to its highest levels in more than four years. The 10-year currently trades at 2.78 percent after hitting a year-to-date high of 2.94 percent on Feb. 21.

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