Hedge funds continue to expand their record bearish Treasuries bets at a remarkable rate, but cooling U.S. inflation and expectations that the Federal Reserve will cut interest rates by up to 100 basis points next year could trigger a powerful short-covering rally.
The latest Commodity Futures Trading Commission (CFTC) figures released on Monday, delayed because of the Veteran’s Day federal holiday on Friday, show that speculators dramatically increased their net short positions in two- and five-year Treasuries futures to fresh record levels.
It is unclear exactly what is behind the recent surge. Some experts point to the “basis trade” - a leveraged arbitrage play profiting from price differences between cash bonds and futures - relative value plays on the yield curve, hedges against other trades, or outright directional bets on U.S. interest rates.
Whatever is driving it, the sheer size of the record short positions and the pace at which they are growing suggest the reversal, when it comes, could be powerful.
Following the release of consumer price inflation data for October on Tuesday, the U.S. bond market opened a window into what that might look like. All yields fell sharply, but especially at the short end - two- and five-year yields plunged by 20 basis points or more, marking the latter’s biggest decline since March.
And there is potential for short-covering from CFTC funds that would, all else equal, push yields even lower.
CFTC data for the week ending Nov. 7 show that non-commercial accounts, often seen as a broad grouping of hedge funds and speculators, grew their net short position in five-year Treasury futures by 231,795 contracts to 1.42 million.
That is a record weekly bearish shift, breaking the previous record of 182,686 in the prior week.
Leveraged funds - those more likely to be active in the basis trade - grew their net short position by 149,000 contracts to 2.08 million, a new record. This is the first break through 2 million, and the position has doubled since March.
In the two-year space, non-commercial accounts grew their net short position slightly to a new record 1.454 million contracts, and leveraged funds’ net short position rose substantially to 1.716 million contracts, also a new record.
A short position is essentially a bet that an asset’s price will fall, and a long position is a bet that it will rise. Falling prices for bonds indicate higher yields, and vice versa.
But funds play Treasuries futures for other reasons, such as the basis trade that regulators this year have flagged as a potential financial stability risk. The difference between cash bond and futures prices is tiny, but funds make their money from leverage in the repo market and the sheer volume of trade.
Overnight repo rates have been steady in recent weeks around 5.35%-5.40%, hovering close to the mid-point of the 5.25%-5.50% federal funds target range, as you would expect. Primary dealers’ general collateral overnight lending has risen in recent months, but not dramatically.
If softer inflation and a more dovish U.S. central bank keep yields under downward pressure, funds’ short Treasuries position is likely to come under increasing pressure too.
Economists at Bank of America on Tuesday changed their Fed call and no longer expect a final rate hike in the current tightening cycle, and the bank’s rates strategists recommend going long five-year Treasuries.
“We now think that the hiking cycle is over. The price action today is consistent with our recommendation to be long the UST 5-year point and in 5s30s nominal curve steepeners,” they wrote in a note to clients.
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