Hedge funds bet against market pessimism on US economic outlook
Some players anticipate steepening yield curve despite it being a trade that inflicted pain this year
Some hedge funds are betting that pricing in the bond market that reflects pessimism about the US economy will not last, remaining in a trade that has cost some of the biggest players billions of dollars this year.
The Federal Reserve’s recent pivot towards a more aggressive strategy to fight elevated inflation has flattened the so-called yield curve, a signal that some investors anticipate that the US central bank’s policy tightening could eventually crimp longer-term economic growth.
The yield curve shows the different interest rates that investors demand for holding shorter and longer-dated government debt.
But traders and strategists say that some hedge funds are wagering that the yield curve will not flatten much more. Instead, they are once again betting that yields on long-term US government bonds will eventually rise, and rise more than yields on shorter-term debt.
Kavi Gupta, Bank of America’s co-head of rates trading, said that funds were indeed “still in steepeners”.
Whether that reflects optimism about the economy is an open question, as the difference in yield between two and 10-year Treasuries — one popular trade — could widen even if economic activity in the US deteriorated.
“The danger is that if the virus ended up being a lot worse than people are saying right now and you get a proper risk-off, then you take some Fed hikes off the table and the market squeezes and there is a steepening,” Gupta added.
Hedge funds have been making this bet on a steeper curve on and off for months, expecting that as economies emerge from coronavirus lockdowns inflation will accelerate and longer-term bonds will sell off, pushing yields higher.
But while it worked in the first few months of this year, the bet proved painful during the spring and early summer, and again in the autumn as the market moved to price in the likelihood that central banks would act to curb inflation.
“It has been very, very difficult to make money from steepeners this year,” said Andrew Beer, managing member at the investment firm Dynamic Beta Investments.
Tumult in the bond market in October battered some big-name macro hedge funds including Chris Rokos and Crispin Odey. Rokos Capital, one of the world’s biggest macro funds, is down about 25 per cent this year to the end of November. Odey’s European fund is up 25 per cent, having been up more than 100 per cent in early October.
Fresh data compiled by the US Commodity Futures Trading Commission also suggests some funds are once again launching steepener trades.
Leveraged funds for the past two weeks have held net bullish bets on two-year Treasuries futures at just below the seven-year high hit in November, CFTC data showed. While the trend weakened slightly in the seven-day period ending December 21, it is notable that it did not soften even more following a strong hawkish signal from the Fed, which lifted yields on the two-year while sinking prices.
At the same time, funds have been increasing their short positions and trimming their long positions in 10-year futures — a bet that prices will fall and yields rise — pushing their net position to the lowest level since March.
“Levered funds were increasing their steepener positions going into the Fed meeting,” said Gennadiy Goldberg, senior US rates strategist at TD Securities. That the positioning has broadly held since the Fed meeting indicates that some hedge funds are moving against the grain.
Decio Nascimento, chief investment officer at the hedge fund firm Norbury Partners, said he had recently put on US steepeners as his fund’s biggest position as the curve had flattened. He highlighted how long-term interest rates on swaps, tools that let investors protect against bond market fluctuations, briefly fell below shorter-term ones, which he said “makes little economic sense”.
Falling Treasury yields — driven by central bank-induced volatility and Omicron-fuelled market swings — contributed in November to hedge funds’ worst performance since the beginning of the pandemic, the data group HFR reported. Among the worst-hit were macro and relative value funds, strategies that have already suffered serious losses this year on bets that the Treasury yield curve would steepen.