Hedge funds re-positioned themselves for last week’s steep rise in short-term U.S. bond yields and implied policy rates, but curiously, not the accompanying burst of dollar strength.
U.S. futures market data shows speculators held their largest short two-year Treasuries position in almost a year, and significantly ramped up their short position in three-month “SOFR” rates contracts back toward April’s record levels.
These were timely moves. The two-year Treasury yield on Friday soared to a 14-year high above 3% after data showed that annual inflation jumped to 8.6% in May, the highest since 1981.
The rise on Friday alone was 25 basis points, effectively the equivalent of a quarter-point rate hike and the biggest one-day increase since 2009.
Secured Overnight Financing Rates rose across the curve too. The June 2023 implied rate, the so-called “terminal” rate where traders currently expect the fed funds policy rate to max out, rose to a one-month high of 3.36%.
Speculators will have lapped this up. The latest Commodity Futures Trading Commission report for the week to June 7 shows that funds increased their net-short position in two-year bonds by more than 40,000 contracts to 170,489, the largest bearish bet since July last year.
Funds increased their net short three-month SOFR position to 529,624 contracts from 442,132 the week before. That’s the biggest week-on-week change since early April and back towards the record short position, also in April, of more than 600,000.
Indeed, gross short positions rose to a new all-time high of 1.139 million contracts.
A short position is essentially a bet that an asset’s price will fall, and a long position is a bet it will rise. In bonds and rates futures, yields and implied rates fall when prices rise, and move up when prices fall.
Fed forecasts are being revised, with some economists and traders now expecting a 75-basis-point rate hike on Thursday, or a higher terminal rate next year. Or both.
“Historically, the U.S. central bank has avoided surprising markets – say, by going 75bp when it is not priced in. But next week, we feel, is likely to be one of the exceptions,” Barclays economists wrote on Friday.
“We think the likelihood of 75bp in either June or July is high, and that the June meeting is most likely.”
The more aggressive U.S. rate outlook, however, was not matched by a bullish shift in funds’ dollar view. They reduced their net long dollar position against a range of currencies for a fourth straight week to $13 billion from $14.7 billion.
That’s the smallest net long in two months.
But last week was hugely significant in currency markets: the European Central Bank signaled it will start raising rates next month, and Japan’s government and central bank issued a rare joint statement expressing concern over the yen’s slump.
The euro slid back to $1.05 after ECB chief Christine Lagarde’s Thursday press conference and the dollar hit a 20-year high against the yen. The broader dollar index’s 2% rise last week was, excluding the peak pandemic volatility of March 2020, one of the best weeks in years.
Funds will surely have shifted dollar positions accordingly.
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