Hedge funds take heavy losses amid Treasury bets ahead of Fed cut, traders say

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Some hedge funds are expected to suffer substantial losses as the spread between long-term and short-term U.S. government debt yields steadily narrows, traders said on Friday.

Concerns about possible losses come as global yield curves flatten, with short-term rates rising at a faster rate than long-term rates – a harbinger of potential economic problems. It’s the opposite of what many expected to happen, especially ahead of the Federal Reserve’s policy meeting in Washington next week.

Global bond markets have seen the curves flatten recently amid expectations that central banks will have to raise interest rates, and therefore increase borrowing costs, in an uncertain economic recovery after COVID-19, the Momentum building further after the Bank of Canada decided on Wednesday to withdraw the stimulus from the COVID era and raise its rate hike projections.

Friday, the spread between 5-TMUBMUSD05Y,
1.186%
and 30-year Treasury rate TMUBMUSD30Y,
1.934%
flattened again to levels not seen since March 2020, and the very short and very long ends of the curve have reversed. In addition, the 5 and 30 yield curves also flattened in the UK, Germany, Italy and France.

Unlike other market participants, a number of hedge funds have relied on leverage to bet on the shape of the yield curve, with many positions for what was supposed to be a sharp rise in yields at long term ahead of an expected announcement by the Federal Reserve will cut its monthly bond purchases by $ 120 billion, traders said. The announcement is expected to be made after a two-day political meeting on Wednesday.

Some of the bets were made via Eurodollar positions, which are seen as a less risky and more liquid way to bet on the shape of the yield curve. Instead of steepening as much as expected, the curve has relentlessly flattened as the outlook for economic growth for fixed-income investors has darkened, leading to a recent wave of selling short-term debt and buying off debt. longer term titles. Debt yields and prices move in the opposite direction.

“Over the past three to four weeks, the leveraged funds have basically set themselves up for a Fed cut that translates into higher rates in the US Treasury market and they have effectively been caught off guard. “By cuts of 10 and 30 per year rates and flattening of the curve,” said trader Tom di Galoma of Seaport Global Holdings in Greenwich, Connecticut.

For much of this year, many strategists expected Treasury yields to eventually rise, with a number of analysts predicting the 10-year Treasury benchmark TMUBMUSD10Y,
1.560%,
used to price everything from mortgages to auto loans would hit 2% by the end of 2021.

“Customers are generally looking for higher rates, just like me, but a lot of people were arrested before the Fed cut and interest rate movements took them out of the game,” di Galoma said over the phone. Friday. “At some point we’re going to see higher rates, it’s just a matter of whether those positions are fully hedged. Some hedge funds are having their best years and others are falling significantly, mainly because they play on this interest rate volatility and are on the wrong side.

Analysts have attributed the recent flattening of the curve in the United States to a number of factors. They include the view that rate hikes will only hamper the recovery of the economy, as well as a more benign view that the economy will likely slow down anyway if the Fed rises and manages to get the economy under control. ‘inflation. A third view is that the desire of many traders to retreat from unprofitable steepening trades has only exacerbated the flattening of the curve.

“There has been some talk about hedge funds about being offside, but I don’t know to what extent,” said Larry Milstein, senior managing director and head of public debt operations at RW Pressprich & Co. in New York. “The movements with the flattening of the curve surprised a lot of people, who expected higher rates. Global central banks have become more responsive to higher inflation, which has caused a significant price revision and may have caused damage to many people. ”

Most Treasury yields were lower on Friday, with the 2-year rate TMUBMUSD02Y,
0.501%
at 0.491%, the 10-year TMUBMUSD10Y,
1.560%
at 1.555% and the 30-year TMUBMUSD30Y,
1.934%
at 1.941%. During this time, the main stock indexes rose, with the Dow Jones DJIA,
+ 0.25%,
S&P 500 SPX Index,
+ 0.19%
and Nasdaq Composite Index COMP,
+ 0.33%
all ending in October at record highs.


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