Investors bet US recovery will force long-term bond yields higher

Investors are running increasingly weighty bets that long-term US government bond prices are about to fall, anticipating that a Democratic win at next month’s US election and progress against Covid-19 could dent the haven assets.

So-called “curve steepener” bets, which profit if long-term yields rise faster than short-term yields, have reached the highest level in a decade, according to John Normand, strategist at JPMorgan Chase. Yields rise as prices fall.

Some hedge funds and other investors have taken short positions using futures contracts tied to 10-year and 30-year Treasuries. Others have bought put options to bet against exchange traded funds that track the price of the bonds, according to market maker Susquehanna. Open interest in such derivatives, a measure of the number of contracts investors are holding, is near its high for the year, Bloomberg data show.

Andrew Sheets, chief cross-asset strategist at Morgan Stanley, said he was among those who felt it was time to “go against the rates market” by betting on a rise in 30-year Treasury yields.

“If you look at how much yields can go down, compared with how much they can go up, it is an attractive trade,” he said. “The two catalysts for reduced uncertainty are a vaccine, which we could have a readout on in the second half of November, and the election.”

Line chart of Option open interest in iShares 20+ year Treasury bond exchange traded fund (000s) showing Investors have bought up put options on long-term Treasury ETFs

Yields on 30-year bonds have been on the way down for almost four decades, and took another leg lower during the coronavirus crisis as panicked investors bought into the assets, perceived as a safe place to park their cash. In late 2018, the so-called long bond yielded close to 3.5 per cent. That has since dropped to about 1.5 per cent.

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The rally has been spurred by the Federal Reserve, which slashed short-term interest rates to near-zero and launched a vast bond-buying programme to offset the economic damage of the Covid-19 crisis. Betting on falling yields has helped macro hedge funds such as Brevan Howard and Caxton Associates make large gains this year.

But long-term yields have inched higher in recent months. Even as money managers bet that short-term interest rates will remain anchored until the US economy regains its pre-pandemic strength, they are not convinced that the Fed will keep the same pressure on longer-dated bond yields.

Recent polling has shown an increasing likelihood of a Democratic sweep, in which Joe Biden wins the presidency and his party clinches both chambers of Congress. Modelling by FiveThirtyEight, the poll tracking website, indicates the Democrats have a 73 per cent chance of taking control of the Senate, up from 61 per cent at the start of the month. Investors believe a Democratic sweep could usher in significantly more stimulus to support the US economy, pushing up inflation expectations, and with them bond yields.

Erik Schiller, head of liquidity at PGIM Fixed Income, said a clean sweep for the Democrats would be a “bearish recipe” for Treasuries, likely pushing 10-year yields back to 1 per cent from the current level of just above 0.7 per cent.

John Brady, a managing director at futures brokerage RJ O’Brien, said that over the past six months asset managers had increased their short bets on 10-year Treasury futures and had dialled back their long positions in 30-year futures.

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He added that the trading suggested asset managers believed there could be “a temporary surge in inflation and thus they are shortening the duration of their Treasury portfolios.”

Line chart of Net positioning among asset managers in Treasury futures contracts showing Asset managers are short 10-year Treasury futures

A number of funds have expressed their concerns over the low level of long-term Treasury yields this year.

Paul Singer’s hedge fund firm Elliott Management has questioned “why on earth” investors would buy longer-dated bonds from major countries, in a letter sent to investors in July and seen by the Financial Times. The letter cites the negative inflation-adjusted income provided by bonds now, and the threat to these assets if price rises were to speed up.

Computer-driven funds have been among those running curve steepener trades, according to Société Générale’s Trend Indicator, which models the positioning of trend-following funds. The model suggests these investors have positive bets on two, five and 10-year Treasuries but turned negative on 30-year bonds about a month ago.

However, with many funds expecting long-term yields to rise, some managers are starting to grow nervous about what they see as a potentially crowded trade. JPMorgan’s Mr Normand warned that such “extreme positioning” in curve steepener trades might limit the profits to be made.

Singapore-based Dymon Asia’s multi-strategy fund is one of those betting on a steeper yield curve. But founding partner Danny Yong, whose fund is up nearly 8 per cent this year, said the demand for yield from investors, and the support of the Fed, would limit the move. “It’s not our strongest conviction [trade],” he added.

Russell Clark, chief executive of Russell Clark Investment Management, the London-based hedge fund firm formerly known as Horseman Capital, sold out of his bond positions earlier this year, according to an investor letter seen by the FT.

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“Treasuries are obvious shorts, just like corporate bonds,” said Mr Clark, whose fund is up 8.4 per cent this year. “The real issue is when will the Fed let [prices] fall,” he added. “On that, I have no idea.”



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