Hedge Funds Place Biggest Ever Short on Benchmark Treasuries

(Bloomberg) — Hedge funds are betting on higher Treasury yields in a market that’s divided over whether the US economy can avoid recession and Federal Reserve interest-rate cuts.

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Recent positioning data suggests leveraged investors are about as confident as the central bank is that a slump be dodged even as the past year’s inflation-fighting policy tightening bites on activity.

That group of investors boosted net shorts on 10-year Treasury futures to a record 1.29 million contracts as of April 18, data from the Commodity Futures Trading Commission show. It was the fifth straight week that net shorts had increased.

“Hedge funds may be thinking that inflation will be stickier than many in the market are currently expecting,” said Damien McColough, head of fixed-income research at Westpac Banking Corp. in Sydney. “On the face of it, this big short doesn’t reflect the view that there will be a near-term recession.”

Still, not everyone in the market is convinced. While swap markets show another quarter-point Fed hike in May is being priced as close-to-certain — and there’s even the marginal possibility of another one in June — they also indicate that the central bank will be cutting in earnest again by the end of the year on the back of a more painful economy.

Also, while leveraged funds have been increasing their bearish wagers on 10-year Treasury futures, other asset managers have been going in the other direction and amping up their longs. With ongoing uncertainty about recession risks and what the Fed will do, it remains very much a two-way market as investors stake out positions on either side of the divide.

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The JPMorgan Chase & Co. Treasury client survey released early last week showed a sharp drop in neutral positions as long bets rose to most since October and shorts hit the highest in nearly two-months.

“Positioning is mixed across the various indicators we monitor,” Bank of America Corp. strategists wrote in a note to clients. “Our futures positioning proxy shows longs are now out of the money and prone to covering, CFTC speculative positioning still historically short, and non-reportable positions & our cross over momentum signal suggest that CTAs are neutral/long duration.”

Treasury yields have been whipsawed in recent weeks as traders engage in a tug-of-war with the Fed amid a growing debate about when policymakers will start cutting rates. Hedge funds will be vindicated if the US central bank prevails in its view that borrowing costs need to keep marching higher.

The group has a checkered track record in Treasuries. Yields declined in 2019 after the previous record short. When leveraged longs hit a multi-year high in 2021, yields did move modestly lower soon after before surging as the Fed headed toward rate hikes.

The 10-year Treasury yield has advanced four basis points this month to 3.51%, although that follows a 45-basis-point drop in March. The benchmark yield remains in a deep discount to two-year rates, suggesting that a downturn is in the cards.

There may be another explanation for the moves. Short positions could be exaggerated by a revival of so-called basis trades, when hedge funds buy cash Treasuries and short the underlying futures, according to James Wilson, a senior portfolio manager at Jamieson Coote Bonds in Melbourne.

The trades involve buying bonds that have become cheap relative to the underlying futures and then selling the futures to pocket the difference. The profit is usually small, hence the tendency to use leverage.

“In a world of huge deficits and no more QE, leveraged funds have a lot more opportunities to reap profits by buying cash bonds and selling the underlying futures where arbitrage opportunities arise,” Wilson said.

(Updates prices, adds comment.)

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