Hedge funds entered February with their largest ever short position in two-year US Treasury bill futures.
This is shown by the most recent data from the Commodity Futures Trading Commission (CFTC), and it goes hand in hand with the rise in the two-year yield, which hit a 16-year high last week, and with the most inverted 2y/10yr yield curve in 40 years.
CFTC positioning data is for the week ending February 7. They are off by three weeks due to a cyberattack a month ago on ION Group’s derivatives platform, which delayed reports from trading companies.
Nonetheless, this is the latest snapshot of how speculative accounts are playing the dramatic repricing of Fed expectations and the short side of the US bond market.
As of February 7, the funds’ net short position in two-year Treasury futures stood at a record 658,802 contracts, an increase of more than 80,000 contracts from the previous week.
Chart 3: 2-year CFTC Treasuries – record net short position,
If the funds have remained on the right side of the continued rise in yields since then, their short position is likely even more important now.
On the other hand, the higher the record short position and the higher the yields – 5% for an essentially risk-free investment will be tempting for many – the closer the bond market is to a powerful rebound.
Chart 1: 2-year US Treasury yield – highest since 2007,
A short position is essentially a bet that the price of an asset will go down, and a long position is a bet that it will go up. In the case of bonds and interest rates, yields and implied rates fall when prices rise, and rise when prices fall.
Hedge funds take positions in short-term US rates and bond futures for hedging and relative value trading purposes, so CFTC data does not reflect purely directional bets. But it’s a pretty good guide.
U-turn on the Fed
Last week, the two-year yield hit 4.95%, the highest level since July 2007. It rose 60 bps in February, the third biggest monthly rise since 2008.
This historic rise smashed the 2s/10s yield curve into a 90bp reversal. An inverted curve has long been considered a reliable indicator of a recession, but many question its usefulness in a twisting post-pandemic world.
Deutsche Bank analysts believe current yields will attract plenty of buyers. They see the two-year yield falling to 3.55% in the third quarter and to 3.15% by the end of the year.
Chart 2: US yield curve 2s/10s – 90 bps inverted,
The market’s reassessment of the outlook for US rates this year has been staggering. In early February, the implied peak of the current cycle of interest rate hikes was below 5% and the year-end rate was around 4.40%.
But the hard-hitting data on inflation and economic activity, and the combative rhetoric from Fed officials that followed, have redrawn the map: Last week, the terminal rate rose above 5.50% and the end of the year exceeded 5.30%.
Perhaps most remarkable of all, the expected rate of inflation implied by the difference in yield between regular and two-year inflation-linked Treasury bonds has crossed the 3% mark. Just six weeks ago, it was 2%.
Put all this together, the idea that the Fed might raise the fed funds rate to 6% this year is no longer the wild imagination it had only a few months ago.
So much so that hedge funds are also replenishing their short position in SOFR interest rate futures after appearing to have completely thrown in the towel on higher rate bets.
In the week ending Feb. 7, the funds were in a net short position of 209,302 three-month SOFR (Secured Overnight Financing Rate) contracts, the largest net short position this year.
The funds’ net short position on SOFR reached 1 million contracts at the end of last August. That stance was gradually erased over the next five months as traders bet the Fed would soon pivot to a pause and then start cutting rates this year.
The rush to bet on higher rates shows that speculators have again turned around, but this time much faster.
(The opinions expressed here are those of the author, columnist for Archyde.com).
Related columns:
– Overshoot of the rate market – or no man’s land?
– Funds start 2023 short on dollars, aiming for peak US rates