Hedge Funds

Commentary: Hedge funds wake up to old market maxim - Don't Fight The Fed

LONDON (Reuters) - Finally, the market looks to be buying into the Fed’s view on U.S. interest rates. And it’s a long time since that’s been the case.

The Federal Reserve building is pictured in Washington, DC, U.S., August 22, 2018. REUTERS/Chris Wattie

Hedge funds and speculators have swung sharply toward pricing in higher rates and yields at the short end of the curve, a sign that they are backing down and now think the Fed will stick to the pace and path of rate hikes it has long flagged.

For most of the post-crisis decade, particularly since the “taper tantrum” in May 2013, financial markets have wagered that slow growth, low inflation and fragile markets will prevent the Fed from tightening policy much.

The Fed is gradually raising rates and shrinking its balance sheet, but the market’s relatively dovish stance for all those years has largely been the right one. It made a mockery of the decades-old market maxim: “Don’t fight the Fed”.

But funds and specs appear to be losing interest in that battle, and are fighting the Fed no more. The latest Commodity Futures Trading Commission figures show they have ramped up their short positions on 30-day fed funds futures contracts and two-year Treasuries futures.

Essentially, they are now betting on a steeper rise in rates and yields at the short end of the U.S. curve than they had previously, buying into the Fed’s guidance of two more rate hikes this year and three next.

CFTC figures for the week ending Sept. 11 show funds virtually doubled their net short position in 30-day fed funds futures to 61,151 contracts, the largest short position since February.

This is the sixth week in a row funds have moved in this direction, the longest run since July-August 2014. The weight of the shift currently underway dwarfs that - as recently as July specs were net long 220,563 contracts, the largest long position in a decade.

Similarly, they increased their net short two-year U.S. Treasuries position last week to 197,128 contracts, also the biggest since February, and kept their 10-year Treasury futures position almost completely unchanged at 682,684 contracts.

Put it together, and the net effect is a bet on a flatter yield curve. This is exactly what is panning out, although this is a “bear” flattening, driven by the short end, rather than a “bull” flattening led by falling yields at the longer end.

The gap between two- and 10-year yields shrank back below 20 basis points last week, and is close to its flattest since 2007. It’s a topic of hot debate whether the flattening curve is a sign of looming economic weakness, low inflation and a rising likelihood the Fed will soon have to cut rates.

But what is indisputable is an inverted curve has preceded every U.S. recession since the 1960s. In terms of warnings from the past about the economic future, curve inversion may be all market participants and policymakers have to go on.

The two-year yield nudged 2.80 pct on Monday, the highest in over a decade, and has risen steadily in line with policy rates since the Fed started hiking in late 2015. The 10-year yield, on the other hand, has for years failed to break and hold above 3.00 pct. It’s right at that level now.

It’s a critical level. The weight of funds’ short positions shows the speculative trading community is clearly betting on a break higher. But the last several years shows it won’t be easy, and last week HSBC recommended buying 10-year Treasuries and with a yield target of 2.80-2.85 pct.

It’s been difficult year for hedge funds in the macro space. Barclayhedge’s Global Macro Index is down 0.69 percent so far this year, only behind Emerging Markets (-6.43 pct) and Pacific Rim Equities (-2.60 pct) as Barclayhedge’s worst-performing sub-index in 2018.

The main hedge fund index is up 1.41 pct.

Eurekahedge’s macro index is down 0.98 pct so far this year, its CTA/Managed Futures index down 1.14 pct year to date, and its fixed income index fell 0.68 pct in August, its worst performance since January 2016.

Further reading:

* WRAPUP 1-Fed has room to raise interest rates for some time, Brainard says

* UPDATE 2-Fed policy to turn mildly restrictive in 2019, Evans says

* UPDATE 1-Fed faces ‘quite challenging’ period keeping recovery on track -Yellen

Reporting by Jamie McGeever; Editing by Toby Chopra