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Treasury Market's Big Short Bet Foiled by Fed Policy Statement

  • FOMC highlights that period of weak inflation continues
  • Dollar bears rewarded as greenback tumbles to 14-month low

The big short in the $14 trillion Treasuries market was short-circuited by the Federal Reserve.

The two-year note yield fell by 3 basis points and five-year yields tumbled by 6 basis points Wednesday after the Federal Open Market Committee left rates unchanged and altered some language in its statement related to inflation. 

The day’s action battered hedge funds and other large speculators, which had built up an unprecedented bet against two-year notes in the futures market. For five-year securities, the group was the most bearish since April. The FOMC statement offered little to suggest an imminent selloff, prompting large futures volumes as traders adjusted positions.

“The statement was hawkish for taper and dovish for rate hikes,” said Ian Lyngen, head of U.S. rates strategy at BMO Capital Markets. “The sector had a massive short that has now been at least partially covered.”

Fed officials removed references to inflation declining “recently” and being “somewhat” below their 2 percent target in a portion of Wednesday’s statement. The central bank’s preferred measure of inflation has declined for three straight months, to 1.4 percent, from 2.1 percent in February.

At the same time, policy makers said they were ready to begin trimming the central bank’s balance sheet “relatively soon.” Strategists saw that as a signal that policy makers will announce the start of tapering at their September meeting.

The Fed also sent the currency market into a frenzy. In this case, the dollar bears were rewarded, with the greenback falling to a 14-month low as measured by the Bloomberg Dollar Spot Index. Traders in Asia extended the selloff on Thursday, with the index sliding toward the 1,150 support level.

Hedge funds have been piling into bearish bets on the dollar, for the biggest net-short stance since 2013. They’ve been spurred on by political headlines as well as interest-rate differentials that have been working against the U.S. currency. The greenback weakened to about $1.1740 per euro, breaching a key level from August 2015 that analysts had been monitoring. 

“It still has legs,” said Carl Forcheski, a director on the corporate currency-sales desk at Societe Generale SA in New York, referring to the dollar’s tumble versus the euro. “The odds of a fairly swift and corrective move have somewhat increased,” with the potential for higher volatility.

— With assistance by Lananh Nguyen, and Katherine Greifeld

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