Why We’re Vulnerable: CTAs’ ‘Oversized Loss’ Betrays Extreme Positioning

You might be wondering what’s next for rates after the rather dramatic move higher we’ve seen in DM yields since Mario Draghi’s June 27 comments in Sintra, Portugal.

As a reminder, this is what started it all where “it all” refers to the mini-tantrum we’ve seen across DMs:

Draghi: While there are still factors that are weighing on the path of inflation, at present they are mainly temporary factors that typically the central bank can look through

That’s right, folks. That seemingly innocuous statement triggered this:

rates

And that, in turn, has everyone on edge.

Well, maybe not everyone. Because despite a record TU short, specs are still (very) long 10Y futs – or at least they were through Tuesday:

10Y

As we put it on Friday evening when the CFTC data hit, “so flattening it is – or at least flattening they think it will be.”

Here’s Deutsche Bank’s assessment, out this evening:

Despite curve steepening, CFTC data for the week ending July 4, 2017, show speculators added flattening positions in 2s-10s and 5s-10s. The difference between TU and TY net positions now stands at a substantial 520k contracts, with speculative investors short 257k TU and long 263k TY contracts. This is the most extreme positioning since before the financial crisis.

SpepcsDB

So consider that, and then consider that CTAs (a crowd that has been in the news quite a bit recently) are likely positioned extremely aggressively.

Here’s DB’s Francis Yared:

A month ago, the market consensus had shifted in favour of carry trades, with many calling for higher equities and lower real rates. This was being reflected in positioning which, on some metrics, was long core rates and long risky assets. For instance, our quantitative team estimates that since mid-April, trend-following CTAs have turned long core rates as well as EM rates (see graph). This is confirmed by an ex-post estimate of the beta of CTAs to US rates (see graph).

CTABeta

And here’s Aleksandar Kocic:

In our view, both 5s/10s and 10s/30s are likely to steepen in a sell off. 5Y5Y about 20-30bp higher is consistent with bearish steepening of 5s/10s in tune with a rebound in risk premia, while 10s/30s could move as much as 20bp due to erosion of liquidity premium and SOMA rundown. Current market positioning would provide positive tailwinds for such outcomes.

CTA positioning indicates that overweight is close to historical extremes. This is the limit when positioning data has its highest contrarian predictability. The figure shows CTA returns overlaid with 10Y UST yield. Whenever the two lines move in the opposite direction, the market is long duration.

CTAPositioning

Recent oversized loss in response to a relatively minor sell off suggests a substantial overweight: A 20bp rise in rates has produced comparable losses as a 50bp sell off across the presidential elections in November. This is reflected in partial beta which quantifies the overweight (Figure 2 above). The figure shows its history (in terms of its z-score) overlaid with subsequent change in 10Y UST yield.

The same data indicates a substantial flattening position as well. This makes rates market vulnerable to sell off and bear steepening.

This would certainly seem to suggest that fears about CTA positioning having the potential to exacerbate a selloff or otherwise add fuel to the fire in a tantrum episode do indeed have some merit.

Trade accordingly.

 

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