Hedge Funds Build Treasury Bets to ’07 High in Bear Rebuke
Hedge funds are the most bullish on 10-year Treasuries since 2007, betting the U.S. economy is too fragile for the Federal Reserve to stop buying bonds even as the jobless rate drops to the lowest in four years and household wealth climbs.
Investors using borrowed funds to boost returns, so-called leveraged accounts, held $56.2 billion in contracts wagering on gains in 10-year Treasury futures in the week ending March 5, data from the Commodity Futures Trading Commission show. That’s the most since just before credit markets froze and the economy went into recession, sparking a rally in government bonds. As recently as July, there were net bets against the Treasuries.
Rather than heading into a bear market after annual returns of 9.5 percent since mid-2007, hedge funds see value in longer- term U.S. debt because of the minimal risk of sudden inflation and higher yields relative to other sovereign securities. Fed Chairman Ben S. Bernanke told Congress Feb. 26 that benefits of buying $85 billion of Treasury and mortgage bonds a month outweigh the potential harm from rising inflation as a result of the purchases.
“It’s just really expensive to fight the Fed,” Jason Evans, co-founder of hedge fund NineAlpha Capital LP in New York and the former head of U.S. government bond trading at Deutsche Bank AG, said in a March 14 telephone interview. “Whether yields have begun a structural rise is not the million dollar question, it’s the multibillion dollar question.”
The economy’s weakness was illustrated March 15, when a measure of consumer confidence fell to the lowest level since 2011. The Thomson Reuters/University of Michigan preliminary sentiment index (SPX) for March dropped to 71.8 from 77.6 in February. The gauge was projected to rise to 78, according to the median estimate of 67 economists surveyed by Bloomberg.
Yields on 10-year Treasuries extended declines from last week as turmoil over a planned tax on Cypriot bank deposits boosted demand for refuge assets. The rate dropped three basis points, or 0.03 percentage point, to 1.96 percent at 12:20 p.m. in New York, according to Bloomberg Bond Trader prices. It slid as much as nine basis points to 1.90 percent, the lowest since March 6 and the biggest intra-day drop since Feb. 25.
The price of the 2 percent security due February 2023 added 12/32, or $3.75 per $1,000 face amount, to 100 12/32.
While the yield is down from more than 5 percent in July 2007, it’s up from a record low of 1.38 percent in July 2012 as more investors switch to riskier assets amid gains in jobs and housing. Economic growth will reach 2.7 percent by year-end from 0.1 percent last quarter, based on the median estimate of economists surveyed by Bloomberg. The Standard & Poor’s 500 Index of stocks is up 10 percent this year, including reinvested dividends.
Investors say it’s not time to abandon Treasuries, because the securities may be cheap relative to inflation. Yields on 10- year notes are about 0.79 percentage point higher than the personal consumption expenditure price index, the Fed’s favored inflation gauge. Earlier this month it reached the most since May 2011. So-called real yields were negative a year ago.
Treasuries due in 10-years or more also yield about 0.54 percentage point more than the average for government debt elsewhere with similar maturities, also the most since 2011, Bank of America Merrill Lynch indexes show. The average since mid-2007 is 0.44 percentage point, with U.S. yields below the rest of the world by as much as 0.2 percentage point in July.
“I’m not convinced that there is any reason yields will go up a lot in the near term,” David Gerstenhaber, who founded New York-based Argonaut Management LP, said in a phone interview March 12. “Yields will likely bounce around in a range.”
The risk for bondholders is if the economy picks up speed. Even after payroll taxes rose on Jan. 1, sales at retailers jumped 1.1 percent in February, the most in five months.
Net worth for households and non-profit groups rose $1.17 trillion from October through December, or 1.8 percent from the previous three months, to $66.1 trillion, the highest since 2007, the Fed said March 7 in its flow of funds report.
“Although there are some near term risks to the U.S. economy due to the pass-through of fiscal policy, overall, we are looking for growth to be at or above trend through the balance of this year,” John Stopford, the London-based head of fixed-income at Investec Asset Management, which oversees more than $100 billion, said by telephone March 13.
The Fed, which meets this week to discuss monetary policy, may slow the pace of bond purchases later this year, causing 10- year Treasury yields to move in a range of 2.5 percent to 3.5 percent, he said. The median estimate of more than 70 economists and strategist surveyed by Bloomberg is for the yield to end the year at 2.25 percent.
While the U.S. may be recovering, most of the world’s major economies are struggling. Growth among the Group of 10 may only be 1.15 percent this year, the least since the recession of 2009, based on the median estimate in separate surveys by Bloomberg.
The number of net-long contracts in 10-year futures held by leveraged accounts stood at 540,397 as of March 12, from 562,057 the prior week. The last time bullish wagers were as high was in August 2007.
There was a net-short position, or bets on rising yields, in July, as rates began to rise from the record low, generating a loss of about 1 percent over the final five months of the year as measured by Bank of America Merrill Lynch indexes.
The total position of leveraged accounts in all interest rate contracts, are $40.4 billion, compared with the record $50.8 billion in December, based on CFTC data tracked by Royal Bank of Scotland Group. These accounts were last year as much as $28.5 billion net short in May.
“It’s not a pivot point for rates right now,” said James Conklin, co-chief investment officer at Greenwich, Connecticut- based $1 billion hedge fund QFS Asset Management LP and former head of investment research at FX Concepts, a currency fund, in a March 15 telephone interview. “An aggressive short in Treasuries is early at this point.”
Whether bond prices rise or fall, many investors see an opportunity to profit from the gap between short- and long-term yields, which are about double the average since 1977.
An investor buying seven-year notes today yielding 1.34 percent would own a security with five years left to maturity in 2015. The current five-year note yields 0.76 percent. That means if yields don’t change, a $10 million investment would earn $531,000, a return of 5.31 percent before leverage.
“The cost of being underinvested in the Treasury market eats you alive every single day,” said NineAlpha’s Evans.
Bernanke told Congress last month that the Fed will keep the benchmark lending rate between zero and 0.25 percent, where it’s been since December 2008, until unemployment falls below 6.5 percent, providing the inflation rate is under 2.5 percent.
“It’s very difficult for you to have a bond market crisis when ultimately the central bank can print money,” Suhail Shaikh, Chief Investment Officer at Fulcrum Asset Management LLP, said in a telephone interview on March 13. The $1.6 billion computer-driven hedge fund group was founded by former British Broadcasting Corp. Chairman Gavyn Davies.
The bullish tilt doesn’t signal that yields are poised to spiral higher, one common outcome when bets are at an extreme, according to James Lee, the head of U.S. derivatives strategy at Royal Bank of Scotland in Stamford, Connecticut.
A broader CFTC gauge that tracks all non-commercial account holdings of interest-rate contracts shows the bets are more balanced. Measured in 10-year equivalents, the market is bullish, or long, in all rate contracts by $3.86 billion as of March 12, down from the record of $66.8 billion reached in September.
“There are other measures of overall speculative positions that aren’t stretched, which signals there is still room for yields to fall,” Lee said in a March 11 interview.
Investors have placed $44 billion with bond managers this year, more than double the almost $20 billion that went to U.S. stock funds, according to the Investment Company Institute. The Fed’s most recent flow of funds data shows the household sector, which includes U.S. hedge funds, private equity funds and personal trusts, increasing Treasury holdings to $1.036 trillion in December from $648 billion a year earlier.
“These leveraged accounts are very suspect on the recovery,” David Keeble, head of fixed-income strategy at Credit Agricole Corporate & Investment Bank in New York, a unit of France’s third largest bank, said in a telephone interview March 8. “And it has been taking a lot to change their minds.”
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