Bond traders going all-in on US Treasury market's big short bet

New York

IT'S not just in meme stocks that the fate of shortsellers is a key theme. Short bets are increasingly in vogue in the US$21 trillion Treasuries market, with crucial implications across asset classes.

The benchmark 10-year yield reached 1.62 per cent last Friday - the highest since February 2020 - before dip buying from foreign investors emerged. Stronger-than-expected job creation and Federal Reserve chair Jerome Powell's seeming lack of concern, for now, with leaping long-term borrowing costs have emboldened traders. In one telltale sign of which way they're leaning, demand to borrow 10-year notes in the repurchase-agreement market is so great that rates have gone negative, likely part of a move to short the maturity.

The trifecta of more fiscal stimulus ahead, ultra-easy monetary policy and an accelerating vaccination campaign is helping to bring a post-pandemic reality into view. There are of course risks to the bearish bond scenario. Most prominently, yields could rise to the point that they spook stocks, and tighten financial conditions generally - a key metric the Fed is focused on for guiding policy. Even so, Wall Street analysts can't seem to lift year-end yield forecasts fast enough.

"There's a lot of tinder being put now on this fire for higher yields," said Margaret Kerins, global head of fixed-income strategy at BMO Capital Markets. "The question is what is the point that higher yields are too high and really put pressure on risk assets and push Powell into action" to try and tamp them down.

Share prices have already shown signs of vulnerability to increasing yields, especially tech-heavy stocks. Another area at risk is the housing market - a bright spot for the economy - with mortgage rates jumping.

The surge in yields and growing confidence in the economic recovery prompted a slew of analysts to recalibrate expectations for 10-year rates this past week. For example, TD Securities and Societe Generale lifted their year-end forecasts to 2 per cent from 1.45 per cent and 1.50 per cent, respectively.

Asset managers, for their part, flipped to most net short on 10-year notes since 2016, the latest Commodity Futures Trading Commission data show.

In the days ahead, however, BMO is eyeing 1.75 per cent as the next key mark, a level last seen in January 2020, weeks before the pandemic sent markets into a chaotic frenzy.

A fresh dose of long-end supply this week may make short positions even more attractive, especially after record-low demand for last month's seven-year auction served as a trigger to push 10-year yields above 1.6 per cent. The Treasury will sell a total of US$62 billion in 10- and 30-year debt.

With expectations for inflation and growth taking flight, traders are signalling that they anticipate the Fed may have to respond more quickly than it is indicated. Eurodollar futures now reflect a quarter-point hike in the first quarter of 2023, but they're starting to suggest that it could come in late 2022. Fed officials have projected they would keep rates near zero until at least the end of 2023.

So while the market is leaning towards loftier yields, the interplay between bonds and stocks is bound to be a huge focus going forward.

"There's definitely that momentum, but the question is how well risky assets adjust to the new paradigm," said Subadra Rajappa, head of US rates strategy at Societe Generale. BLOOMBERG