With a record pile up of shorts stalking the benchmark 10Y US Treasury…
… institutional funds who have been patiently betting against low yields in the United States and Europe are about to enjoy a big payday, as rates continue to rise across the globe and inflation finally picks up as the Phillips curve stirs from its decade-long coma.
Money managers like Goldman Sachs, Franklin Templeton and Aviva Investors are all part of a group of brand name investors who recently doubled down on short positions on long dated government debt. According to JPMorgan data , the largest 20 Euro mutual funds will also profit from the move as most of them shifted aggressively to short duration stances last month, suggesting they are in a good position for the “perfect storm” that has hit rates markets in recent days.
Bonds are falling as a result of “strong” macroeconomic data in the US, continued “hawkish” sentiment from the Federal Reserve and strong commodity prices. At the same time German bund prices have dropped precipitously in sympathy, and also as a result of receding fears over Italy’s fiscal policy and the country’s corresponding economic trajectory (at least for now, that is as the Italian turmoil is far from over).
As such, all those who have been betting for some type of “normalization” in the bond market may receive their validation soon. James McAlevey, portfolio manager of the Aviva Investors Multi-Strategy Fixed Income Fund, told Bloomberg:
“We have a structural short duration position in the U.S. because we expect the Federal Reserve will continue normalizing policy and that inflation will increase as jobs growth and wage pressure builds. Market participants are at a point where they can start to have a conversation about shorting the European bond market.”
In anticipation of the move, Goldman went underweight European rates in its $3.4 billion strategic income fund over the summer. That added to the fund’s already negative duration stance and was catalyzed by the expectation that the ECB would start rising interest rates, following in the footsteps of the United States.
Franklin Templeton similarly reduced duration in its flagship global bond fund to minus 1.14 years at the end of the second-quarter. The manager of that fund stated on Bloomberg that he believed treasury yields could rise as high as 4%. Both of these funds have outperformed most of their peers over the last month.
And while the strong, if not overheating, US economy is the primary catalyst for the selloff, the double whammy has been the absence of new buyers. Yesterday, we highlighted Bill Gross’ thoughts on why foreign buyers – traditionally among the most passionate purchasers of US duration – have been absent. As Gross explained, the reason is the same as what we had noted in previous reports: a jump in hedging (or funding) costs.
“Euroland, Japanese previous buyers of 10yr Treasuries have been priced out of market due to changes in hedge costs,” Bill Gross tweeted Wednesday. “For insurance companies in Germany/Japan for instance, U.S. Treasuries yield only -.10%/-.01%.”
Gross was referring to the falling cross-currency basis, which has driven U.S. 10-year equivalent, or hedged yields to -0.06% for European investors and 0.09% for Japanese buyers who hedge against currency fluctuations through swaps, as the following Bloomberg chart shows:
Whatever the reason behind the sharp drop in US paper, others have been focused on Europe where yields are far lower. DWS Group reduced the European interest-rate risk in its $130 billion multi-asset portfolios. Money manager Christian Hille told Bloomberg, “The risk of being wrong on the long-duration side in Europe is much higher than in the U.S.”
Many funds have struggled with this trade over the course of the last year. Funds like Franklin Templeton have underperformed as they waited for yields to climb. They believe now, more than ever, that the time is right for such positioning.
Hille and other strategists expect the growth and inflation trajectory for the Euro area to stay on course, ultimately resulting in the ECB to normalize policy next year.
Now, if only they knew what “normalize” meant, and perhaps more to the point, how long before “normalized” rates result in the next recession, sending yields plummeting as the ECB is forced to renew its QE, and restarting the yield cycle from scratch.
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