Hedge Funds Risk Treasuries Wipeout After Bearish Bets Soar
By Brian Chappatta and Liz McCormick
There’s a big showdown looming in the U.S. Treasury market.
The “fast money,” made up of hedge funds and other speculators, upped its bearish bets like never before this month, based on futures data for five-year notes. At the same time, “real-money” accounts, composed of institutional buyers like mutual funds and insurers, did the opposite and built up their bullish positions in much the same way.
What will happen, especially in the era of Donald Trump, is anyone’s guess. But for JPMorgan Chase & Co.’s Jay Barry, the speculators are sowing their own demise. While Treasuries have suffered five straight months of losses, fast-money investors tend to be reliable contrarian indicators whenever they crowd together. More than 75 percent of the time, the market moves the other way over the following month, his figures show. The recent backup in yields is already starting to lure long-term investors back into Treasuries.“I’m surprised the speculative data remains as short as it does,” said Barry, a U.S. fixed-income strategist at JPMorgan.
The disparity isn’t just a difference of opinion. In important ways, it reflects deeper questions about the direction of the U.S. economy. Some investors see President Trump as a game-changer, whose spending plans will unleash growth (which has failed to top 3 percent in any year since the recession ended in 2009) and spur higher borrowing costs. Others see demographics, high debt levels and income inequality as structural reasons for growth to remain subpar.
Barry says investors should buy five-year notes because they’re currently a better value than shorter- or longer-dated U.S. securities.
Since early July, yields on five-year Treasuries have roughly doubled to 1.87 percent. Much of the selloff has occurred since November, when Trump’s upset victory in the presidential election led to speculation his policies will result in faster inflation and more interest-rate hikes by the Federal Reserve.
Leveraged funds that use borrowed money to boost returns see even more losses ahead. As of Jan. 10, their short positions — futures that pay off if five-year notes lose value — exceeded longs by a record 1.1 million contracts, data compiled by the U.S. Commodity Futures Trading Commission show.
While it’s been the winning strategy over the past several months, institutional buyers are undaunted. Not only did they boost their long positions for five-year notes to an all-time high this month, but they’ve also stepped up bullish bets on 10- and 30-year Treasuries as well. (Most recent data as of Jan. 17 showed a slight pullback in both institutional net longs and leveraged net shorts.)
When real-money investors do go all-in, they tend to overwhelm the fast-money crowd because of their sheer size.
In the end, “real money always wins,” said Tom di Galoma, the managing director of government trading and strategy at Seaport Global Holdings. “Speculators tend to get taken out. We’ve seen this occur several times in the last 10 to 15 years, where everybody thinks rates are too low.”
Count Prudential Financial Inc.’s Robert Tipp among those in the real-money camp who are taking advantage of the recent selloff. He predicts the bond market’s hysteria over Trump’s proposals to stimulate growth will subside and prompt investors who abandoned Treasuries to return.
“It seems like the bulk of opinion is still leaning toward higher rates,” said Tipp, head of global bonds at Prudential’s PGIM fixed-income division, which oversees more than $650 billion. “I’m dubious.”
The firm has been paring its holdings of corporate bonds and adding longer-maturity government debt.
A shift back into Treasuries may already be starting. Fixed-income managers who oversee a combined $225 billion held 24.7 percent of their assets in U.S. government debt in the week through Jan. 17, according to a client survey from Stone & McCarthy Research Associates. That’s higher than the average of 24.2 percent in 2016.
However, signs of even a slightly more aggressive Fed can still make the bearish trades worthwhile. Last week, Fed Chair Janet Yellen said rates could rise “a few times a year” from now through 2019. That caused five-year yields to soar by the most since the central bank raised rates Dec. 14.
In the past, the Fed has been notorious for being too confident about growth and the pace of rate increases. Jason Evans, co-founder of hedge fund NineAlpha Capital LP and the former head of U.S. government bond trading at Deutsche Bank AG, believes this time the central bank will stick by its projections and lift rates three times in 2017.
“It’s understandable that there’s going to be a little ebb and flow,” said Evans, who said his firm put on short positions this month. Even so, “we’ll have higher yields later this year. We at least know the direction we’re heading in.”
Traders have raised their expectations in the wake of Trump’s victory. The Fed’s effective rate will reach 1.12 percent in a year’s time, based on overnight index swaps. That implies about two more increases in 2017. The day before the election, traders were pricing in a rate of 0.69 percent.
Regardless, JPMorgan’s Barry says the fast money should exercise caution when it comes to bets on higher yields. It’s not a foregone conclusion Congress will rubber-stamp all of Trump’s stimulus plans — which include infrastructure spending, tax cuts and reduced regulation — as fast as the markets expect. And there’s no guarantee they will immediately translate into higher growth.
There’s a risk “when you lean positions too far in one direction,” he said.