Developed market bond yields have risen sharply off the August lows amid optimism on trade, movement on Brexit and generalized hopes that rate cuts and dovish forward guidance may be about to manifest themselves in better growth and inflation outcomes.
It’s also crucial to remember that the plunge in bond yields that defined August was something of a false optic.
During a client presentation late that month, JPMorgan’s Josh Younger documented the extent to which fundamentals explained “less than half of the move in rates and inversion of the yield curve”. On his estimates, the rally in bonds was attributable to a “combination of positioning, hedging activity and poor liquidity conditions”.
The bank’s Marko Kolanovic reiterated that in a note out Monday.
“The move in bond yields in August (down) was magnified by the trade war escalation, but also by technical moves such as interest rates option hedging, mortgage hedging, insurance liability hedging, CTA crowding into bonds, and momentum crowding and rebalances of equity quants”, he remarked, on the way to reminding everyone that those drivers “can also work in reverse, which started happening this September and is likely to continue”.
Well, on Tuesday, Nomura’s Charlie McElligott is out with some additional color on the CTA side of things.
“Within Bonds, we are nearing the potential for a pivot in the 2019 legacy ‘Long TY’ position held in our CTA Trend model—as we are now projecting the 3m window to flip ‘short’ in 4 days”, Charlie wrote, in a note just before lunchtime on Tuesday.
Critically, the 3m window is the largest weighting in the model. Here are the specifics:
Our CTA model uses 5 look-back tenors across which we have an aggregated ‘buy’ or ‘sell’ signal across the accumulated windows—and as of right now, the 3m window now has now become the most “loaded” input at 57.8% of the overall weighting.
Obviously, if the largest weighing flips, that will have an outsized impact on the aggregate signal.
This is, potentially anyway, a very notable development. As you can imagine, the CTA position in bonds has been maxed out long for most of this year amid the voracious rally/inexorable decline in yields.
“The signal is ‘long’ while the actual gross exposure to the trade moves up or down via leverage deployment and per the vol- and price trend- signal”, McElligott writes, adding that for context, the overall TY position hasn’t been “short” since November 30th of last year, which he reminds you was before the narrative pivoted decisively towards the notion that the Fed had, in fact, tightened the economy into a slowdown, which in turn contributed to the massive risk-off sentiment that dominated December, the worst month for US equities since the Great Depression.
So, looking ahead, Charlie notes that “if today’s price level was held constant looking out 4 days from today, the current legacy ‘+100% Long’ signal in TY [would] flip to a ‘-15.5% SHORT’ position”.
As you can see from the visual, that’s on account of the 3m window pivoting due in no small part to a couple of big “up” days for 10-year futures falling out of the calculation.
What does that mean? Well, potentially it could add to the bearish impulse in bonds, in line with what Kolanovic alluded to on Monday when he mentioned “CTA crowding”, “momentum crowding” and the possibility for the drivers which pushed yields sharply lower in August to “work in reverse”.
“This would drive mechanical selling / de-leveraging flows from what has been one of the largest ‘gross $ exposure’ positions in the model all year”, McElligott said Tuesday.