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This under-the-radar policy risk could set off a tantrum in rates at the next Fed meeting

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Wall Street may be underpricing a near-term risk associated with Fed policy

Wall Street may be underpricing a risk associated with the next Federal Reserve meeting on interest rates.

According to Richard Bernstein Advisors' Michael Contopoulos, it may come down to President-elect Joe Biden's pick for Treasury secretary: former Fed Chair Janet Yellen.

Contopoulos speculates the Fed could see her appointment as a dovish influence and it may overcompensate — essentially changing its typical behavior.

"What you could have is a situation where Chair [Jerome] Powell tries to get Congress to act on a large stimulus package and doesn't necessarily sound as dovish as what the market expects," the firm's director of fixed income told CNBC's "Trading Nation" on Thursday. "That's a tail risk."

Contopoulos, Bank of America Merrill Lynch's former head of high yield strategy, noted it's not his base case. But he said he believes it's a risk investors should take seriously because the low probability event could set off a temporary tantrum in rates.

"It's certainly something the market isn't talking about. So, I think it's going to be an interesting meeting," he said. "It's something you always want to keep your eye on."

Why rates may not roar back

Longer-term, Contopoulos is confident interest rates are on an upward trajectory as the economy recovers. He believes Capitol Hill will pass another round of massive virus relief.

"You have fiscal stimulus talks starting to accelerate, and you have positive news around a vaccine," Contopoulos said. "Much of this is just the growth story for 2021, and the Treasury market is starting to price that in somewhere similar to what stocks have already done."

Contopoulos' forecast calls for higher rates, but he doesn't expect them to move higher in a straight line or roar back.

He predicts the benchmark 10-year Treasury Note yield will end the year around 1% due to tug-and-pull activity surrounding the current virus situation. Next year, he sees the yield running into resistance around 1.20%.

On Thursday, it closed at 0.91%. The 10-year yield is now up 47% since early September.

Disclaimer

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Treasury market is starting to price in a 2021 growth story, top strategist says