Column-Hedge Funds Still Betting On That Elusive Fed Pivot: McGeever

They'll be proved right one day, just not yet.

Hedge funds continue to bet that the U.S. Federal Reserve will end its aggressive interest rate hiking cycle soon enough, then after a brief pause begin easing policy as growth and inflation come down.

But as U.S. inflation, inflation expectations, and Fed officials indicate, this pivot is a ways away - the Fed's implied terminal rate last week shot to a new high just shy of 5.00%, the 2-year Treasury yield hit a 15-year high above 4.50%, and the '2s/10s' yield curve was its most inverted since 2000.

The Commodity Futures Trading Commission report for the week through Oct. 11 shows that hedge funds cut their net short position in three-month Secured Overnight Financing Rate futures to 552,462 contracts from 618,830 the week before. This was the fourth straight week that funds have reduced their collective bet on rising U.S. interest rates.

A short position is essentially a wager that an asset's price will fall, and a long position is a bet it will rise. In bonds and rates, yields fall when prices rise, and move up when prices fall.

Hedge funds take positions in short-dated U.S. rates and bonds futures for hedging purposes, so the CFTC data are not reflective of purely directional bets. But they are a pretty good guide.

Funds are now holding the smallest net short three-month SOFR position since July, and it has pretty much halved in the last six weeks.

(CFTC funds' SOFR position https://fingfx.thomsonreuters.com/gfx/mkt/klpykxwjkpg/CFTCSOFR.png)

UPSIDE RISK

Granted, at more than 1 million contracts in late August and early September, not only was that a record short position, it was significantly bigger than anything seen before. The leveraged trading community had probably got too bearish.

So a retreat was always likely. But the pullback has coincided with a continued grind higher in short-term rates, yields, and Fed expectations. Traders last week briefly priced in a one-in-ten probability that the Fed's next move in a couple of weeks will be a 100 basis point hike.

(SOFR implied rates - 2023 https://fingfx.thomsonreuters.com/gfx/mkt/dwvkrowqdpm/sofr.png)

"Given that high core services inflation should persist over the near term, there is some upside risk that the Fed would have to go more aggressive in tightening ... either by year-end or in terms of hiking for longer," TD Securities analysts wrote on Friday.

Macro hedge fund strategies are significantly outperforming benchmark markets and hedge fund strategies this year because funds have largely been on the right side of the huge moves in the dollar, commodities, and rates.

Hedge fund industry data provider HFR's Macro Index was up 12.83% in the first nine months of the year. It is well on course for its biggest annual rise since it was launched, beating the previous best of 6.3% from 2010.

INVERTED CURVE

Funds have fared better with their U.S. yield curve flattening trades in recent weeks.

The latest CFTC figures show that speculators trimmed their net short position in 10-year Treasuries to 340,163 contracts in the week ending Oct. 11 from 366,872 the week before.

They also increased their net short dollar two-year Treasuries futures position to 353,686 contracts from 306,134.

There have only been 11 weeks of bigger net short positions since the contract's launch over 30 years ago.

Citi's rates strategy team reckons short rates may struggle to go much higher from here because the "vicious synergy" from rising borrowing costs has already significantly tightened financial conditions and increased market volatility.

"With 2s already at 4.5% and the terminal Fed funds rate in March 2023 almost at 5%, it seems unlikely that 2s can sell-off much more in the near term. There may not be more to go in 2s/10s flattening," they wrote on Friday.

(US 2s/10s yield curve https://fingfx.thomsonreuters.com/gfx/mkt/xmpjozmqrvr/2s10s.png)

(The opinions expressed here are those of the author, a columnist for Reuters.)

Related columns:

Central banks still U.S. bond buyers - but FX campaigns may jar (Oct. 11)

Fed's neutral rate forecast nods to 'transitory', eventual pivot (Sept. 28)

(By Jamie McGeever; Editing by Ana Nicolaci da Costa)