Stimulus trade runs counter to several large hedge funds

Investors are reassessing their commitment to the reflation trade that captivated Wall Street this year after a warmongering inclination by the US central bank inflicted losses on some fund managers.

Betting against the price of US government bonds was a winning game earlier this year, with hedge funds and other investors making sizable gains as the economic recovery gained momentum. But recent gyrations and the specter of a political pivot from the Federal Reserve have raised serious doubts about whether investors should stay in the trade.

“It’s evident that the reflation trade has been flushed out,” said Thanos Bardas, deputy director of investments for fixed income at Neuberger Berman. “The market overreacted, [but] the uncertainty has increased.

Several well-known hedge funds have been caught in the maelstrom, including Caxton Associates of Andrew Law and Rokos Capital of Chris Rokos.

The rationale for stimulus trade centered on expectations that the acceleration of the U.S. vaccination program and the removal of Covid-19 lockdown measures would usher in a period of high growth and inflation as business activity began to decline. normalize.

The Fed’s insistence that it also look beyond the rapid rise in consumer prices in the United States, which it deemed temporary, before adjusting its ultra-accommodative monetary policy has encouraged investors to take a position against longer-term Treasuries. Long-term debt tends to suffer disproportionately from inflation, as it erodes the value to investors of interest payments that are “fixed” for a period that spans many years.

Hedge funds have crammed into the trade, betting it was the next big win after taking advantage of rising US Treasuries prices last year. Caxton, one of the top performing hedge funds in 2020, wrote in December that “the stage may well be set for a big reflation.” Some funds bet bond prices will fall, while others take positions against the dollar.

In recent months have taken the shine of this trade, with further purchases of 10-year Treasuries pushing yields down to recent highs recorded in March 2021 despite larger-than-expected increases in consumer prices. But it was the June meeting of US central bankers and emerging signals that the Fed may not be as tolerant of higher inflation than expected under the new policy framework it unveiled last August that dealt the blow. most important to date.

After initially selling sharply after the meeting – which opened the door for two interest rate hikes in 2023 – U.S. government bond prices soared as investors wondered how to decipher the slightly less accommodating tone of the Fed. This price hike pushed the benchmark 10-year yield to 1.35% this month, from highs of nearly 1.8% in March. It has since stabilized at around 1.50 percent.

The two-year note, more sensitive to monetary policy adjustments, moved higher, with yields rising 0.11 percentage points since the start of the month to 0.26%. This has led to a rapid flattening of the yield curve, which tracks the difference between long and short term Treasury yields.

“What happened was a bit of a reinterpretation of what the Fed [framework] really means, ”said Michael De Pass, global head of US government bond operations at Citadel Securities. “The ‘let it run’ narrative may not be as pronounced as market participants expected.”

2-year government bond line graph (%) showing that the Fed's policy change signal is pushing short-term yields higher

He added: “Confidence in the [reflation trade] was dented.

The price fluctuations were in part amplified by the positioning of funds before the Fed meeting. According to CFTC data, the so-called “steeper” bets that benefit when longer-term treasury prices fall at a faster rate than shorter-term notes were particularly crowded ahead of the Fed meeting, according to the Fed. CFTC data.

Caxton suffered an approximately 8% drop in its $ 2 billion Macro fund, which is still up this year, people who had seen the numbers said.

Brevan Howard lost around 1.5% in his main fund in June and 2.9% in a fund managed by trader Alfredo Saitta. Rokos has lost around 4% this month, according to people familiar with his performance. Rokos and Brevan declined to comment, while Caxton did not respond to a request for comment.

While some managers have been burned by the reversal of the reflation trade, others are holding on, using the recent “positioning erasure” – as one trader put it – as a buying opportunity.

“Nothing in our opinion has changed. We’re all in the reflation business,” said Bob Michele, chief investment officer at JPMorgan Asset Management, who noted his team had increased their bets in recent days. “We believe that there is a lot of growth and inflationary pressures building up in the economy. [and] we are only halfway to reopening at the national level. “

Dan Ivascyn, group chief investment officer at Pimco, also believes that long-term Treasury yields should rise from there, given that the risk of inflation is “on the upside.” But he warned the road ahead could be bumpy.

“You are in a period where valuations are much more strained,[and]it takes less bad news to create the same amount of volatility, ”Ivascyn said. “You want to keep checking your thinking. “

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