Hedge funds go into this week’s Fed meeting holding one of their gloomiest-ever outlooks for U.S. Treasuries, with the heaviest selling pressure now being cranked up on 10-year bonds.
The latest Chicago futures market data captures some of the most frenzied activity in Treasuries for years, as investors brace for an imminent start to the Fed’s tapering and bring forward the anticipated liftoff on interest rates to the middle of next year.
As inflation worries persist, investors are accelerating the pace of bond selling, bond market volatility is soaring, and the longer end of the yield curve is flattening dramatically, even inverting.
Commodity Futures Trading Commission data for the week to Oct. 26 shows that funds dumped a net 114,301 contracts of 10-year Treasuries futures, extending their net short position to 114,845 contracts, the largest short since May last year.
The scale of funds’ long liquidation recently is almost without precedent. October’s unwind of 296,052 contracts was the biggest monthly swing to short positioning since March 2005, and the second-largest since the contract’s launch in the mid-1980s.
The Fed is expected to announce on Wednesday that it will soon start unwinding its $120-billion-a-month bond buying program. Investors are now anticipating the first rate hike to follow shortly after the tapering is complete, in mid-2022.
Figures on Friday showed that one key measure of annual inflation in September was 4.4 per cent, continuing a run at levels not seen in 30 years. But core inflation was 3.6 per cent, the same as the previous three months, and a sign that price pressures may be waning.
As evidenced by the wild gyrations in rate expectations and short-term yields elsewhere – notably Britain, Australia and Canada – the Fed’s decision this week is coming at a crucial juncture for world markets.
“We are entering perhaps the most interesting phase for global monetary policy in living memory – that is, if you are under 50 or so,” wrote former IMF economist Chris Marsh in a new Substack post “Money: Inside and Out.”
HISTORIC FLATTENING
Amid the thick fog of uncertainty surrounding all economic indicators due to the pandemic, it seems clear that funds are betting price pressures will prove more persistent, putting the Fed in a tighter bind.
CFTC data shows that funds extended their net short position in 5-year Treasury futures last week by 86,264 contracts to 341,475, the largest net short this year. They also extended their net short position in 30-year futures by 19,436 contracts to 331,213 contracts, the largest short since August last year.
Broadly speaking, less aggressive selling at the long end of the curve shows that investors believe the Fed jacking up rates in the near term will choke growth and depress the terminal rate of interest.
In sum, it shows a skepticism about how much the Fed can raise rates over the longer term.
Some of the recent curve-flattening, especially at the longer end, has been dramatic. The gap between 10– and 30-year yields last week shrank to its smallest since early 2019, and the 20s/30s curve inverted for the first time ever.
In October, the 10s/30s curve flattened by 18 basis points, the most for a single month since September 2011.
The scale of these moves has provided hedge funds with something they crave – market volatility. Both three-month and six-month implied Treasury volatility last week rose to the highest since March last year..
It is certainly paying to be short Treasuries. While the Barclays benchmark U.S. government bond index was flat in October, it is down 2.7 per cent this year, on course for only its fourth annual loss in quarter of a century.
But HSBC’s Steve Major, one of the world’s foremost proponents of the view that the upside for yields is limited, last week repeated his view that it is inflation expectations that seem most out of sync, not low yields.
“Our view has not changed. Unless the balance of longer-run fundamentals – those that explain lower-for-longer rates – starts moving into reverse, then yields will stay at the lower end of the range,” he wrote in a note.
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