Investors are reassessing their convictions in the deflationary trade that has captured Wall Street this year after falcon tilt By the US central bank incurred some fund managers losses.
Betting on US government bond prices was a winning game earlier this year, as hedge funds and other investors made big gains as the economic recovery accelerated. But recent volatility and the specter of pivotal policy from the Federal Reserve have created significant doubts about whether investors should stay in the trade.
“It is clear that the deflation trade has rinsed off,” said Thanos Bardas, vice president of investment for fixed income at Neuberger Berman. “The market has overreacted, [but] Uncertainty increased.
Several big-name hedge funds have been caught in the whirlpool of the storm, including Andrew Law’s Caxton Associates and Chris Rokos Capital’s Rokos Capital.
The rationale for deflation trading centered around expectations that an accelerated vaccination program in the United States and the removal of Covid-19 lockdown measures would lead to a period of high growth and inflation as business activity began to return to normal.
The Fed’s insistence that it would also outpace rapidly rising US consumer prices, which it considered temporary, before adjusting its ultra-loose monetary policy, encouraged investors to take a stand against long-term Treasuries. Long-term debt tends to suffer disproportionately from inflation because it erodes value for investors from “fixed” interest payments over a period of many years.
Hedge funds piled into the trade, betting it was the next big win after benefiting from last year’s surge in US Treasuries. Caxton, one of the best performing hedge funds of 2020, wrote in December that “the stage may be set for a major downturn.” Some funds bet on bonds, while others bet on dollar deals.
Recent months have taken shine on From this trade, with renewed buying in 10-year Treasuries, yields are well below the recent highs recorded in March 2021 despite larger-than-expected jumps in consumer prices. But it was the US central bankers’ meeting in June and nascent signals that the Fed might not be as tolerant of higher inflation as previously expected under the new policy framework unveiled last August that delivered the most significant blow yet.
After an initially sharp sell-off after the meeting – which opened the door to two rate hikes in 2023 – US government bond prices soared as investors wrestled over how to decipher the Fed’s less dovish tone. That rally pushed the benchmark 10-year yield to a low of 1.35 percent this month, from a high of about 1.8 percent in March. It has since settled at around 1.50 per cent.
Two-year bonds, which are more sensitive to monetary policy adjustments, turned higher, with yields up 0.11 percentage point since the start of the month to 0.26 percent. This has resulted in a rapid flattening of the yield curve, which measures the difference between long- and short-term Treasury yields.
“What happened was a kind of reinterpretation of what the Fed does [framework] “Really mean,” said Michael De Pas, global head of US government bond trading at Citadel. “Let It Run Hot” may not be as clear as market participants expected.
He added: “Trust in [reflation trade] may be dented.”
Price volatility was in part amplified by how the money was laid before the Fed meeting. According to CFTC data, so-called “steep-dip” bets that profit when long-term Treasury prices fall faster than short-term banknotes were crowded ahead of the Fed meeting.
Caxton suffered a decline of about 8 percent in its $2 billion Macro fund, which remains high this year, said people who have seen the numbers.
Brevan Howard lost nearly 1.5 percent in his main fund in June and 2.9 percent in a fund managed by trader Alfredo Saita. Rokos has lost about 4 percent this month, according to people familiar with its performance. Roccus and Brevan declined to comment, while Caxton did not respond to a request for comment.
While some managers have been burned by the deflation trade reversal, others are holding on, using the recent “whitewashing of positions” – as one trader described it – as a buying opportunity.
“Nothing has changed in our opinion. We are all in the deflationary trade,” said Bob Michel, chief investment officer at JPMorgan Asset Management, noting that his team has added to its sharp bets in recent days. We think there’s a lot of growth and inflationary pressures building in Economy. . . [and] We are only halfway through reopening locally.”
Dan Evaskin, group chief investment officer at Pimco, sees long-term Treasury yields likely to rise from here, given that inflation risks are “on the upside”. But he cautioned that the path forward could be bumpy.
“You are in a period where the ratings are stretching further,[and]“It takes less bad news to create the same amount of volatility,” Ivaskin said. “You want to keep checking your thinking.”
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