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With worries over U.S. economic growth now rivaling deeper-rooted concerns over inflation, hedge funds have slashed their bearish Treasuries bets by the most on record and bond market volatility has climbed to a 13-year high.

This is how speculators are going into the Federal Reserve’s May 3-4 meeting, where policymakers are expected to raise interest rates by 50 basis points for the first time since 2000. A 75-basis point increase would be the biggest since 1994.

But the hawkish fervor of recent months is taking its toll. The S&P 500 has had its worst January-April performance since the 1930s, the economy contracted in the first quarter, and financial conditions are tightening rapidly.

Funds took the opportunity to significantly reduce their net short 10-year Treasuries position ahead of the Fed’s meeting. That will have been prompted by profit-taking too - macro funds just had their best first quarter since 1993.

Commodity Futures Trading Commission data for the week to April 26 show that funds’ net short position fell by more than 200,000 contracts to 117,817, the smallest since October.

The scale of the shift was historic. It was the most bullish weekly swing in net positioning since 2017 and the second largest on record. In terms of gross short positions only, it was the biggest reduction ever.

A short position is essentially a bet that an asset’s price will fall, and a long position is a bet it will rise. In bonds, yields rise when prices fall, and move lower when prices rise.

VOL TO PLAY FOR

The move was also reflected in spot markets - the 10-year yield fell sharply to 2.72% from 2.98% in that week, the peak ‘terminal rate’ around the middle of next year implied by Eurodollar futures fell around 25 basis points, and the gap between two- and 10-year yields shrank.

Yields and implied rates have since snapped higher again, however, even though the initial snapshot of the economy in the first quarter showed a 1.4% slump in output, and there are signs that inflation may have peaked.

The Fed takes center stage this week, with balance sheet reduction plans likely to be unveiled also. ‘Quantitative tightening’ will be scrutinized by investors just as closely as the decision and guidance on interest rates.

Achieving a soft landing for the economy while successfully snuffing out the highest inflation in 40 years is a challenging balancing act. It is perhaps little surprise that, as the Fed appears comfortable with the rapid tightening of financial conditions, bond market volatility is soaring.

Last week the three-month ICE Bank of America MOVE index of implied Treasury market volatility rose to 127.17, the highest since August 2009.

Analysts at TD Securities reckon the Fed will not want to “overdo” policy tightening above neutral if it looks like growth and/or inflation are about to fall.

The Fed’s estimate of the long-term ‘neutral’ rate of interest is 2.4%, but Eurodollar futures market pricing has rates remaining above 3% for at least the next five years. This is a disconnect that cannot persist for long.

“Rates are likely to remain extremely volatile in the near-term as markets remain uncertain about how quickly the Fed will deliver tightening,” TD Securities analysts wrote on Friday.

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