Deutsche Bank's George Saravelos has stated that market sentiment toward fixed income assets swung sharply to extremely bearish this year, but this pessimism has become excessive because the market is underestimating the risk that a problem in the artificial intelligence (AI) sector could trigger a flood of capital into bonds.

Saravelos, Deutsche Bank's global head of foreign exchange research, said in a report on Friday that during meetings with clients in the United States, he found that investors worry AI is "a major driver of rising yields, and that the U.S. Treasury has lost control of the long end." He also noted that these factors have fueled speculation that the U.S. Treasury might pause issuance of 20-year Treasury bonds, while the vast majority of clients are bearish on French bonds following a sharp sell-off.

This stands in stark contrast to last year's market narrative, when AI was seen as potentially helping to cool inflation, and the U.S. Treasury's efforts to stem rising yields were considered credible.

"The pendulum of the narrative has swung a bit too far in the other direction," Saravelos said. "The biggest systemic risk facing the market next year is not France, but the AI ecosystem 'going wrong' — whether it's a safety incident, a failed IPO, or disappointing revenue," he said. "Concentration risk is very large, and this event risk — which is bad for the dollar and very good for bonds — is currently the most underestimated risk in the market."

U.S. Treasury yields have risen to multi-decade highs. The conflict with Iran has sent energy prices soaring, exacerbating inflation concerns, while the U.S. economy remains strong. AI infrastructure spending is boosting the economy while also increasing the amount of debt that investors need to absorb.

Saravelos believes that if the market reprices AI risk, it would be beneficial for bonds. As for French bonds, he told clients that some of investors' concerns appear to be exaggerated. "We explained why we disagree with drawing parallels between the current situation and 2010 to 2015, but given the massive dislocation in the market last week, it will clearly take time for market confidence to recover," he said. "This has put new pressure on the euro, which we had not expected to see this year."