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Hedge Funds' Biggest Short in Bonds Faces Make-or-Break Moment

(Bloomberg) -- Hedge funds and other large speculators are more convinced than ever that the 2018 bond-market rout will resume in the days ahead.

The group, known for trading on momentum, boosted short bets in 10-year Treasury futures to a record 939,351 contracts, according to Commodity Futures Trading Commission data through Feb. 6. That means the violent market moves on Feb. 5, when the Dow Jones Industrial Average suffered an unprecedented drop and 10-year yields fell almost 14 basis points, weren’t enough to dissuade wagers that rates are headed higher. The next gut-check comes Wednesday, with the latest read on consumer prices.

Hedge Funds' Biggest Short in Bonds Faces Make-or-Break Moment

Speculators’ positioning matters because it can push momentum to extremes, and can serve as a contrarian indicator since these traders are among the quickest to switch directions when prices turn against them. By contrast, longer-term holders like asset managers are seen as more likely to stay the course. Their net long in 10-year futures is the highest since October 2015.

The question facing Treasuries traders throughout the 2018 selloff is whether something is truly different this time that will push yields ever higher. After all, asset managers have been adding to long positions for months, and 10-year yields just keep setting multi-year highs. At the very least, investors may be recalibrating to a higher yield range.

The speculators’ stance “signals people think the 10-year has more value at 3-plus percent than at 2.85 percent,” said Ben Emons, head of credit portfolio management at Intellectus Partners LLC. “Anecdotal evidence suggests more pent-up demand for duration at 3 percent, especially by long-only players.”

Monitoring 3%

Traders and strategists have been watching for a clean break of recent highs as a signal that 10-year yields are headed to 3 percent. That’s more than just a round number -- it approximates the peaks set in late 2013 and early 2014, before the bond bull market drove yields to record lows.

While it’s easy to point to momentum traders as the reason for the losses in Treasuries, there’s plenty of rationale for the leap in yields. The Federal Reserve is showing few signs of deviating from its rate-hike path and continues to trim its balance sheet; the Treasury is issuing more debt to cover widening deficits; and wage growth is finally showing signs of accelerating, meaning inflation could be on the rise.

The speculators’ wagers may face some headwinds. After 10-year yields touched 2.893 percent Monday, the highest level in four years, they fell to 2.86 percent. There’s a risk that the January consumer price index data on Wednesday could trigger a bond-market reversal, with the core reading expected to fall on an annual basis.

Pain Rotation

For now, the buildup in short positions is understandable, given 10-year Treasuries are bearing the brunt of the action surrounding the prospect of higher yields, said George Goncalves, head of Americas fixed-income strategy at Nomura Securities. Two- and five-year yields had already been rising last year as the Fed raised rates, while the 30-year yield remains stubbornly below its 2017 high.

With the 10-year note ending little changed last week, relative-strength index analysis signals it’s not as oversold as it was earlier this month. That gives speculators some breathing room to gain on their short wager. 

At some point, the buildup in bets against Treasuries could prove unsustainable. But, as bond investors have learned time and again this year, going against momentum can be costly.

©2018 Bloomberg L.P.