LONDON (Reuters) - Speculators are making their biggest bet ever on higher short-term U.S. bond yields, as they scramble to anticipate the Fed’s responding to bubbling growth and inflationary pressures by jacking up the cost of borrowing.
The recent change in outlook for the U.S. bond market has been sudden and dramatic, strengthening the view that a major re-rating of U.S. - and therefore global - borrowing costs is now underway.
A month ago, the difference between 10-year and two-year U.S. yields shrank to less than 50 basis points, the smallest gap in over a decade. This yield curve flatness hinted at weak inflation pressures and a steady-as-she-goes Fed.
The Fed had raised rates five times since December 2015 and was expected to raise them at least twice more this year. But that relatively benign view is now being called into question, especially after figures on Friday showed that U.S. wage growth last year reached 2.9 percent, the highest since 2009.
Chicago Futures Trading Commission data for the week to Jan. 30 show that hedge funds and speculative investors increased their net short position in two-year U.S. Treasury futures to a record 329,066 contracts.
(For a graphic showing CFTC US 2-year Treasuries positioning, click here: reut.rs/2EGRArp)
That’s an increase of 27,980 from the week before. A short position is effectively a bet an asset will depreciate in value, and a long position is a bet it will appreciate. Falling bond prices means yields rise, and vice versa.
The two-year U.S. bond yield has consistently been making post-crisis highs for around five months, and on Friday nudged 2.19 percent.
Not only are nominal Treasury yields climbing to their highest in years, financial markets at large are beginning to feel the heat. After an unprecedented run-up to record highs, stocks around the world are finally beginning to wobble.
Wall Street fell around 4 percent last week, the biggest weekly fall in more than two years, and major indexes around the world have opened this week in the red again. Big shifts in the bond market are at the root of it.
(For a graphic showing S&P 500 - weekly change, click here: reut.rs/2E0RnxT)
New Fed Chair Jerome Powell, who is being officially sworn in on Monday, has backed his predecessor Janet Yellen’s view that the Fed should stick with its path of “gradual” rate hikes. But the bond market rout underway could change that.
The Atlanta Fed last week raised its GDPNow model forecast for first-quarter GDP growth to a seasonally adjusted annual rate of 5.4 percent. That is a volatile number and liable to be drastically revised, but still, that’s a punchy forecast.
Certainly, investors and traders are pricing in higher rates and yields. The CFTC net short positioning in 10-year Treasury futures also increased in the latest week to 215,600 contracts, the biggest net short since March last year.
The 10-year yield rose to a four-year high of 2.885 percent on Monday. The rise in the 10-year yield has been more dramatic than the rise in the two-year yield in recent weeks, which has steepened the yield curve to 73 basis points from below 50 basis points last month.
A flattening yield curve historically suggests financial markets are anticipating slowing growth, and a steepening curve points to stronger growth and inflationary pressures.
The snap back in yields and the yield curve has sparked a long-awaited rise in market volatility. Implied volatility in U.S. Treasuries has just posted its biggest two-week increase in over a year, and one of the biggest in several years.
(For a graphic showing U.S. Treasuries implied volatility, click here: reut.rs/2EGTwQH)
With the bond market having moved so far in such a short space of time, a reversal may be on the cards. Whether it comes, and how short-lived or not it is, will go a long way to determining the near-term outlook for U.S. and global markets.
The opinions expressed here are those of the author, a columnist for Reuters.
Reporting by Jamie McGeever, editing by Larry King