Even as the annual central bank festival at Jackson Hole approaches – all online again like so many other live events in the time of COVID-19 – hedge funds remain remarkably cool on the outlook for higher U.S. interest rates and bond yields.
The Kansas City Federal Reserve event in Wyoming will be held remotely once again this year – though it still provides Fed Chair Jerome Powell with an opportunity to signal a key policy shift in a keynote address.
Markets have for many weeks now looked to the address as a moment when Powell might at least outline the sequencing for the Fed tapering bond purchases and then raising rates, perhaps as early as next year, assuming the economy continues to improve.
But with the COVID-19 Delta variant spreading across the United States and supply chain disruptions persisting, many economists are lowering their growth outlooks. Funds and speculators are drawing in their horns slightly too.
Commodity Futures Trading Commission figures for the week ending Aug. 17 show that funds maintained a net long position in 10-year Treasury futures for a sixth straight week, and were net long two-year Treasuries for a third week.
The notable rise in net long 10-year positions, coupled with a slight reduction in net longs at the shorter end, meant funds effectively put on yield curve ‘flattening’ positions, often seen as a warning sign for the longer-term growth outlook.
Although small, the positioning in two-year notes merits closer attention. As the chart below shows, funds have been net short for three whole years – almost four – effectively betting to varying degrees on higher yields and tighter Fed policy.
But they flipped to net long earlier this month, suggesting either a general unwind and position fatigue, or a more fundamental change of view. The next two weeks covering Powell’s speech and the August non-farm payrolls report could be pivotal.
On the 10-year Treasury futures, CFTC funds’ net long 145,216 contracts is the third-largest this year and fourth- biggest since 2017, signalling a growing belief that upside potential for the 10-year yield is fading.
FLATTENING THE CURVE
The benchmark 10-year cash yield has drifted to around 1.25% from 1.75% in March. Strategists at JP Morgan and Goldman Sachs recently trimmed their year-end forecast (although they still expect it to rise), while at the dovish end of the spectrum HSBC earlier this month maintained its 1.0% call.
The decline in yields appears to have wrong-footed many funds since March. According to hedge fund industry data provider Eurekahedge, macro and fixed income strategies were virtually flat in July, bringing their year-to-date gains to 4.59% and 3.77%, respectively.
These strategies are under-performing Eurekahedge’s broad hedge fund index, which is up 7.97% year-to-date.
Meanwhile, market research firm Preqin data shows that July was the first month in 10 to produce a negative return for hedge funds, with a loss of 0.45% undoing gains of 0.46% in June.
The next two weeks could go a long way to determining funds’ next steps, although the path ahead is far from clear cut.
If Powell doesn’t show a firm commitment to exiting super-easy policy soon and the U.S. jobs report for August is on the soft side, the tendency is likely to be for lower long-term yields and more curve flattening.
A relatively hawkish speech from Powell and strong job growth, however, may not necessarily shift the dial in the other direction, given that the last few months showed Treasuries rallying alongside increasing expectations of Fed tapering.
A hawkish surprise from Powell, just as the economy shows signs of peak growth, could raise fears of a Fed policy error, leading to lower long-term yields and flatter yield curve.
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