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Commentary: Record U.S. yield curve bets plunge into red as inversion looms

LONDON (Reuters) - Hedge funds are doubling down on their bets that the U.S. yield curve will steepen, just as it flattens to within 20 basis points of inversion, historically a sure-fire indication that the economy is headed for a slowdown.

Traders work on the floor at the New York Stock Exchange (NYSE) at the end of the day's trading in Manhattan, New York, U.S., August 27, 2018. REUTERS/Andrew Kelly

Whether slowdown morphs into recession, as every curve inversion in the last 45 years has reliably predicted, is almost irrelevant for those betting on the shape of the curve. What matters is they’re on the wrong side of the trade and losing money. Fast.

The latest Commodity Futures Trading Commission figures show hedge funds and speculators now hold a record net short position of 700,514 contracts in 10-year Treasury futures, and a short position of 97,333 contracts in two-year futures.

That’s the second week in a row the difference between the two has been more than 600,000 contracts, an unprecedented gap since the tracking of CFTC positioning data started in 1995.

 (Graphic: Hedge funds & Yield curve:

Just over a year ago, funds were flipped sharply the other way: net short two-year futures by around 255,000 contracts and net long 10-year futures by around 300,000 contracts, resulting in the biggest curve flattening position in a decade.

That ultimately paid off, and the curve is now its flattest and closest to inverting since 2007. Will funds have the patience to stick with their steepener bets now?

CFTC data show that the net short position in 10-year futures has swollen by 616,848 contracts so far in 2018, well on course for a calendar year record, while the two-year net short position has roughly halved.

But the 10-year yield has failed to hold above 3.00 percent, and is now hovering around 2.80 to 2.85 percent. The two-year yield, which is more sensitive to expectations of continued rate hikes in the coming months, has largely held around 2.60 to 2.65 percent.

Barclayhedge’s Global Macro Index is down 1.23 percent so far this year, only behind Emerging Markets and Pacific Rim Equities as Barclayhedge’s worst-performing sub-index. The main hedge fund index is up only 1.11 percent, but at least it’s up.

Eurekahedge’s global fixed income index is up 1.26 percent so far this year, but other strategies in which Treasuries feature heavily are under water. The Macro Fund index is down 0.48 percent year to date, the CTA/Managed Futures index is down 2.08 percent, and the Trend Following index is down 4.50 percent.

The shape of the curve and its signals continue to split market participants and policymakers alike, as highlighted in the minutes of the Fed’s latest policy meeting published last week.

“Several” participants noted the curve’s predictive powers and suggested policymakers pay “close attention” to the shape of the curve. Others believed “inferring economic causality from statistical correlations was not appropriate.”

Research published by the San Francisco Fed on Monday found “no clear evidence in the data that ‘this time is different’,” but stopped short of dismissing the warning signs flashed by the flattening curve completely.

“The recent evolution of the yield curve suggests that recession risk might be rising. Still, the flattening yield curve provides no sign of an impending recession,” the paper concluded.

Those on the wrong side of the yield curve trade might take some comfort from the fact that they’re not the worst-performing funds out there. BarclayHedge’s CTA Cryptocurrency Traders Index is down 42.45 pct this year.

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

Further reading:

Powell sets Fed's course with data-based judgment

Fed's Bullard warns of recession risk in raising rates

Reporting by Jamie McGeever, editing by Larry King