Hedge funds bet against market pessimism over US economic outlook

Some hedge funds are betting bond market prices that reflect pessimism about the U.S. economy won’t last, remaining in a trade that has cost some of the biggest players billions of dollars this year.

The Federal Reserve’s recent pivot to a more aggressive strategy to tackle high inflation has flattened the yield curve, a sign that some investors expect that tightening U.S. central bank policy could potentially dampen economic growth in the long run. term.

The yield curve shows the different interest rates that investors charge to hold shorter and longer term government debt.

But traders and strategists say some hedge funds are betting the yield curve won’t flatten much more. Instead, they are betting once again that long-term U.S. government bond yields will eventually rise, and more than short-term debt yields.

Kavi Gupta, co-head of rate trading at Bank of America, said the funds were indeed “still steepening”.

Whether this reflects optimism about the economy is an open question, as the difference in yield between two-year and 10-year Treasuries – a popular trade – could widen even as economic activity in the States- States was deteriorating.

“The danger is that if the virus ends up being a lot worse than what people are saying right now and you get appropriate risk, then you take a few hikes out of the Fed and the market contracts and there is a steepening.” , Gupta added.

Hedge funds have been making this bet on a steeper curve for months, expecting that as economies emerge from coronavirus lockdowns inflation to accelerate and longer-term bonds to sell off, driving up yields.

But while it worked in the first few months of this year, the bet proved painful in the spring and early summer and then again in the fall as the market assessed the likelihood of central banks taking action. to curb inflation.

“It has been very, very difficult to make money with pentisers this year,” said Andrew Beer, managing member of investment firm Dynamic Beta Investments.

The uproar in the bond market in October hit some large macro hedge funds, including Chris Rokos and Crispin Odey. Rokos Capital, one of the largest macro funds in the world, is down about 25% this year at the end of November. Odey’s European fund is up 25 percent, after rising more than 100 percent in early October.

New data compiled by the U.S. Commodity Futures Trading Commission also suggests that some funds are once again initiating steeper trades.

Leveraged funds over the past two weeks have held net bullish bets on two-year Treasury bill futures just below the seven-year high reached in November, according to CFTC data. While the trend weakened slightly over the seven-day period ending December 21, it should be noted that it has not weakened yet following a strong hawkish signal from the Fed, which noted yields over the two-year period while driving down prices.

At the same time, the funds increased their short positions and reduced their long positions in 10-year futures – a bet on falling prices and rising yields – pushing their net position to the lowest level since March.

“Leverage funds were increasing their steepening positions ahead of the Fed meeting,” said Gennadiy Goldberg, senior US rates strategist at TD Securities. The fact that the positioning has largely been maintained since the Fed meeting indicates that some hedge funds are moving against the tide.

Decio Nascimento, chief investment officer at hedge fund firm Norbury Partners, said he recently put his fund’s biggest position on US steepings as the curve flattened. He highlighted how long-term interest rates on swaps, tools that allow investors to hedge against fluctuations in the bond market, briefly fell below shorter-term interest rates, which, according to him, “does not make economic sense”.

Column chart of the net number of contracts held by leveraged funds (in thousands) showing the net positions of leveraged funds in 10-year Treasury futures

Falling Treasury yields – driven by central bank-induced volatility and Omicron-fueled market swings – contributed to the worst performance of hedge funds in November since the start of the pandemic, the HFR data group reported. Among the hardest hit are macro and relative value funds, strategies that have already suffered heavy losses this year on bets that the Treasury yield curve steepens.

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