(Bloomberg) — Bond traders who were stung by the recent market rout are growing increasingly bearish ahead of what many expect to be hawkish guidance from the Federal Reserve.
U.S. Treasuries posted their worst performance in seven months in April, with growing evidence of economic resilience and stubborn inflation prompting investors to reduce their bets on a Fed interest rate cut and instead focus on short bets. Traders who began the year anticipating multiple cuts in 2024 now anticipate just one full quarter-point cut – and some are now wondering whether or not the central bank will act.
Fed speakers, including Chairman Jerome Powell, have indicated in recent weeks that they are prepared to keep rates higher for longer if the data continues to come in. Investors expect to hear the same thing from the Fed chairman on Wednesday. That left them defensive and betting on further losses, even after U.S. yields climbed across the board to their highest level since November.
“Short-term bond trading is back,” said Kathryn Kaminski, chief research strategist and portfolio manager at the AlphaSimplex Group quant fund, which established a new bearish stance in February. “This month in particular, you’re seeing the short bond exposure work really well.”
Read more: 60,000 headlines show Powell’s hawkish pivot has just begun
Futures market data for the week to April 23 showed hedge funds building short positions. Commodity trading advisors, or CTAs, have also joined the party and now serve at a “short maximum term,” according to Bank of America strategists. Meanwhile, in the spot market, JPMorgan Chase & Co.’s latest client survey showed short bets hitting their highest levels in three weeks.
Futures activity focused on near-term maturities shows that open interest (the number of positions held by traders) increased as US 2-year yields crossed the 5% level. This indicates that new bearish positions are primarily driving the selling, rather than profit-taking on bullish bets.
Despite some signs of profit taking during Friday’s session following the release of inflation data, shorts continue to dominate. Traders even strengthened their bearish bets on Tuesday after a higher-than-expected reading in the Fed’s preferred wage gauge.
Read more: Bond traders rush to cover short positions after inflation data
“We said in February that the short signals had kind of come back and we were looking for a real breakout,” said Kaminski of AlphaSimplex. “This month we have witnessed this revolutionary movement.”
Certainly, more episodes of short-selling coverage could arise as traders seek to lock in profits at high yield levels. And with markets now so bearish, it’s possible that Treasuries could rebound on Wednesday, Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets, wrote in a note this week.
“Should investors prepare for a sell-the-rumor, buy-the-fact dynamic when Powell comes on the scene? We suspect so,” Lyngen added.
Bank of America strategists note, however, that near-term maturities could be vulnerable to further losses, as traders close bullish positions that are now “out of the money.”
Here is an overview of the latest positioning indicators on the rates market:
Hedge funds reinstate shorts
Leveraged accounts added to net short positions in Treasury futures by about 100,000 10-year note futures equivalents in the week to April 23, Commodity data suggests Futures Trading Commission. They took the other side of asset manager positioning changes, where net long positions were expanded by almost 200,000 equivalents of 10-year bond futures. Hedge funds extended their net short positions in two-year bond futures to hit a new record.
Treasury clients add short and long positions
JPMorgan’s latest survey showed short and long positions rose four percentage points over the week, with neutral positions losing eight percentage points. In total, short positions are at their highest level since April 8, while long positions are at their highest level since April 15.
SOFR Most Active Options
Recent activity in SOFR options has seen the largest increase in open interest between the 96.00 and 97.00 strike prices, largely reflecting continued buying of the SOFR call spread from the 24 December 96.00/97.00. Friday’s flow included buying the 15,000 bullish structure at a 5.5 tick level, which took the positioning up to around 165,000. The dovish hedge targets a Fed rate as low as 3 % by the end of the year. The largest liquidation occurred at the 94.9375 strike price during the week, reflecting the unwinding of positions during the June 24 SOFR calls.
Heatmap of SOFR options
The most crowded SOFR options up to the December 24 content remain the 95.00 level, equivalent to a 5% rate, where large amounts of open interest remain in the June 24 calls, which also constitute the Most of the open interest outstanding in the 95.50 strike. Positioning also strengthens in the 96.00 and 97.00 strike prices, reflecting demand for the December 24 SOFR 96.00/97.00 call spreads.
Reduction in premium in the event of bond sales
The premium on options intended to hedge a sell-off in long-term Treasuries continues to erode, although it remains expensive relative to the so-called belly-and-front, where the premium is close to the neutrality. Recent flows in the Treasury options market have included a long short on the 5-year term targeting an increase in the yield to 4.85% by the end of May, and a short position of 5.5 million dollars via June 10-year options.
–With help from Liz Capo McCormick.
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