LONDON (Reuters) - The U.S. bond market is at a turning point, with the 10-year yield finally making a convincing break above 3 percent, paving the way for a more prolonged rise in U.S. borrowing costs.
This is pushing the dollar to its highest level this year, threatening a similarly prolonged rise in the U.S. currency and a double tightening whammy for global financial conditions. Trillions of dollars of loans around the world, especially in emerging markets, are tied to U.S. yields and the dollar.
Whether this trend continues may depend on what hedge funds and speculators do next. In the decade since the 2008 crisis, there has been a pretty good correlation between turning points in speculators’ positioning and turning points in the dollar and U.S. bond market.
If that relationship is to hold up this time around, the dollar could continue to strengthen but it’s less clear where bond yields go.
Commodity Futures Trading Commission figures show that late last month hedge funds and specs held a record net short position in 10-year Treasuries and a record net long euro position. Their overall net dollar position was the biggest short in seven years.
They’ve started to unwind those positions. The euro has fallen almost 5 percent against the dollar and the 10-year yield has struggled to make that break above 3 pct. Until now.
Let’s start with Treasuries.
Rising yields will draw investment into U.S. bonds from across the investment community, including pension funds, insurance funds, multi-asset portfolio managers and FX reserve managers. These flows will act as a downward force on yields.
Despite the recent short covering, CFTC specs’ outstanding net short position remains massive at over 400,000 contracts. Do they continue to cover, or do they increase that short position with the yield now at a seven-year high of 3.07 pct and threatening to go higher still?
The inverse correlation between CFTC spec positions and the 10-year yield has held up for much of the post-crisis decade, barring the 2013-15 period.
(For a graphic showing U.S. 10y yield vs CFTC spec positions, click here: reut.rs/2rKDxMf)
In early 2009 CFTC specs went from broadly neutral to a then record net short of 275,000 contracts in April 2010. The yield shot up from just under 3.00 pct to 3.95 pct.
A flip to a net long position just under 100,000 contracts by the end of that year coincided with the yield falling back to 2.40 pct.
A build up of long positions over 2012 culminated in a net long of over 200,000 contracts in December that year. The yield bottomed out in July just under 1.5 pct.
The next time CFTC positions rose to a historically high net long, around 185,000 contracts in July 2016, the yield was down at a multi-decade low of 1.32 pct.
By May 2017, CFTC specs had amassed a large net long position of more than 360,000 contracts and the yield had eased back down towards 2 pct from 2.60 pct.
The subsequent liquidation and flip to record net short of over 460,000 contracts within a year has coincided with the yield rising above 3 pct for the first time since 2014.
If we take the CFTC euro position as a proxy for the dollar, we again see a close correlation between position turning points and the euro.
(For a graphic showing Euro vs CFTC spec positions, click here: reut.rs/2rFJJoH)
In May 2007 speculators were net long a record 119,000 contracts, but the euro didn’t peak until a year later at just under $1.60.
The correlation tightened between 2009 and 2015. A then record net short 110,000 contracts in May 2010 coincided with the euro at a four-year low of $1.20, before both flipped over the next year to a net long 100,000 contracts and $1.48.
The deepening euro crisis triggered something of a speculative run on the euro, culminating in then record short position of 214,000 contracts in June 2012, a month before Mario Draghi’s “whatever it takes” speech.
The euro bottomed out at $1.2150 in July, and as CFTC spec positions flipped to 72,000 net long in October 2013 the euro rose to $1.39 a month later.
The euro then went into steep decline, and looked like breaking below parity with the dollar in early 2015. It troughed at just under $1.05 in March that year, just as specs amassed what remains a record net short position of 226,000 contracts.
The relationship broke down over the next 18 months or so but picked up again in early 2017 - CFTC specs went from a net short 140,000 contracts to a record long 151,000, and the euro rallied from under $1.05 to $1.25 a few months ago.
If the current longs are liquidated, the euro’s slide could have much further to run.
The opinions expressed here are those of the author, a columnist for Reuters.
Reporting by Jamie McGeever; Graphics by Jamie McGeever; Editing by Matthew Mpoke Bigg