Most Wall Street analysts predicted a bear market for bonds in 2014 and got it wrong. Who's to say they'll get it right this year?

After all, today's consensus forecast is similar to what it was a year ago: U.S. government-bond yields will finally start climbing as the Federal Reserve prepares to raise interest rates. Analysts predict benchmark 10-year yields will rise to 3.06 percent by year-end, up from 2.05 percent today.

This seems reasonable if oil prices stabilize after plunging as much as 50 percent in 2014. And if U.S. economic growth accelerates to a 3 percent rate from 2.3 percent last year, as predicted in a Bloomberg survey of analysts. And if Europe also avoids deflation as policy makers pump stimulus into the region.

Here's an alternative narrative that would cause those assumptions to unravel:

1) Oil falls further from prices that are already at five-year lows, spurring a wave of defaults among more than US$200 billion of outstanding U.S. energy-related high-yield bonds. UBS Group AG analysts said last month that the default rate for this segment could more than double this year to 10 percent if prices on West Texas Intermediate crude stay near $50 a barrel.

Prices dropped to $50.73 a barrel as of 9:45 a.m. in New York.

2) Junk bonds tend to be a leading indicator for U.S. equities, which are supposed to post another year of gains, according to pretty much every major Wall Street analyst surveyed by Bloomberg.

While speculative-grade securities had a rough time in 2014, delivering their worst annual return since 2008, the Standard & Poor's 500 Index gained 11.4 percent even as economists cut their predictions for global growth.

“The bond market is saying there's a better chance than you think that there's a 10 percent correction in the first half of the year” for stocks, Jim Bianco, president of Bianco Research LLC, said in a telephone interview last month.

If stocks follow junk bonds down, that may be a problem for the Fed because it would be hard to justify a rate increase with equities tumbling, he said.

3) The U.S. dollar will climb this year to the highest level since 2003 relative to six major peers, according to a Bloomberg survey. While that's a sign of growing confidence in the world's biggest economy, it's also a problem for developing nations that have sold a record amount of dollar-denominated bonds.

The size of the Bank of America Merrill Lynch U.S. Emerging Markets External Debt Sovereign & Corporate Index has swelled to $1.6 trillion of securities, from $496.3 billion eight years ago. As currencies of Brazil to Russia lose value, it'll effectively cost more and more for those nations to repay their debt issued in dollars.

A rash of insolvencies on sovereign debt would no doubt hurt risk appetite and economic growth, sending investors back to safe-haven assets—in other words, U.S. Treasuries.

4) The European Central Bank may fail to come through with a stimulus package that meets the market's expectations.

“Mario Draghi has been very lucky to have the market to do what he wants to do without spending any money,” Jonathan Mackay, senior market strategist at Morgan Stanley's $2 trillion wealth-management unit, said last month in a telephone interview.

Italy's debt gained 15.1 percent last year and French bonds returned 12.1 percent. The securities may be poised to lose if it becomes clear that the ECB isn't about to engage in more extensive bond buying.

The potential for Greece to exit the monetary union doesn't help the region's outlook, either. That would prompt an event that University of California at Berkeley economist Barry Eichengreen called “Lehman Brothers squared” in a panel discussion this past weekend.

One thing is certain, according to Mackay: “Nothing happens the way that the consensus sees it happening.”

Instant Insights /

Contrarian Narrative on the Bond Market

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