Winning Short Trade on Treasuries Faces Potential Fed Roadblock

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(Bloomberg) -- The Federal Reserve’s interest-rate decision this week may halt the momentum of some recent winning trades in the Treasuries market.

Open interest data on futures suggest that the volume of bets against near-term maturities has been rising, helping to explain why two-year U.S. yields on Tuesday touched the highest level since 2008. It’s certainly proven a good wager of late: two-year Treasury notes have weakened in 24 of the past 27 weeks and the shift higher in short-end rates has left the yield curve close to its flattest level in more than a decade.

Based on positioning though, the risk now is for the surge in short-term U.S. yields to pause and for the curve to steepen after the Federal Open Market Committee’s meeting ends Wednesday. While Fed Chairman Jerome Powell and his colleagues will almost certainly raise the central bank’s benchmark lending rate this week, and may well end up hiking four times this year, they’re seen as unlikely to signal such an aggressive intention just yet.

The lack of a fourth 2018 rate hike built into the Fed’s new “dot plot” projections, combined with what looks to be a crowded bet against short-term Treasuries, might be enough to lead speculators who are wagering on even-higher yields to take profits or close their positions. They held a record net short in two-year note futures earlier this year.

On the other hand, those same traders are less bearish than before on longer-dated Treasuries, according to Commodity Futures Trading Commission data. Hedge funds and other large speculators pared their net short position in 10-year futures by 90,781 contracts in the week through March 13, the biggest such pullback in eight weeks. That helps explain the support for that part of the curve early last week, but it also leaves a clearer path for higher yields if the Fed is more optimistic about the economic outlook.

High Fives

Put together, the yield curve from 2 to 10 years may be poised to steepen, at least briefly, after coming close to the flattest since 2007.

Five-year yields on Tuesday were just shy of their highest level since 2010 and speculators are close to a record net short futures position in the maturity. But since the notes are more sensitive to the Fed’s interest-rate outlook in the years ahead, they’re vulnerable if policy makers raise their median dot projections for 2019, 2020 or the longer run.

The long bond, by contrast, saw unprecedented interest from speculators after a better-than-expected auction last week. Their net increase of 69,271 contracts was the most in CFTC data going back to 1993.

That may signal the yield curve from 5 to 30 years will flatten, rather than steepen, as long as traders don’t unwind their positions. It would continue a trend seen throughout this year of that portion of the curve remaining flatter than the segment from 2 to 10 years.

In currencies, on the other hand, a signal that Fed policy is set to tighten more rapidly might be the outcome that catches markets more off guard. If traders view the Fed as more hawkish than anticipated, that could push real interest rates higher and boost the U.S. dollar, according to Canadian Imperial Bank of Commerce’s Bipan Rai. CFTC positioning shows speculators are still largely betting on further greenback losses, so a move up could force them out of those wagers.

©2018 Bloomberg L.P.

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