Last week, I wrote that seemingly everyone has coalesced around some variation on a bearish rates theme.
It was hardly a novel observation. Between inflation jitters and the prospect of preemptive rate hikes aimed at short-circuiting the expectations channel (at the risk of choking off growth and upsetting a dozen years of established behavioral patterns), market participants are almost uniformly pessimistic on bonds.
In the latest installment of BofA’s Global Fund Manager survey, global bond allocations dropped to the lowest level ever.
Read more: Cognitive Dissonance And The Bond Bears
As the title of the linked article suggests, there’s a bit of cognitive dissonance at work. Market participants are turning more bearish on the outlook for global growth and a consensus is building around the idea that preemptive rate hikes for risk management purposes could backfire, especially considering the questionable effectiveness of higher policy rates when the problem is cost-push inflation.
If you harbor a dour outlook on global growth and you think rate hikes are likely to make things worse, it doesn’t take a leap of logic to conclude that central banks might think twice before pulling the trigger and that, ultimately, demand destruction tied to surging prices might undermine the “overheat” narrative, especially in the event a winter COVID wave in the Northern Hemisphere piles more pressure on economies.
Juxtaposed with crowded positioning, the risk of a reversal in consensus bearish rates trades thus appears to be elevated. Nomura’s Charlie McElligott on Monday described a potential “major market ‘reversal’ risk” considering how far various expressions of that trade have been pushed.
He flagged more spec selling in futures, including -$3.8 billion of TU, the most since March, and almost $13 billion in TY the most since Donald Trump was elected (figure on the left, below).
In addition, asset managers sold another $8.8 billion last week on top of the previous week’s record selling. “The highlight here is that the net AM position in TU has now pushed outright negative for the first time since December 2015,” McElligott wrote. December 2015 was, of course, the month when liftoff commenced in the US (on a delay — it was “supposed” to commence in September of 2015, but China’s overnight yuan devaluation in August forced a rethink).
And then there’s the “extreme bearish” skew at the front-end (figure on the right, above, from Nomura’s Sam Wen).
Meanwhile, the bank’s CTA model shows net G10 bond exposure in just the 3.9%ile.
Critically, the trigger for a squeeze need not be something dramatic. McElligott cited a number of potential catalysts, including a growth slowdown.
In addition, he noted the Fed is removing “a lot” of duration this week, reiterated that the taper will be offset by reduced supply (i.e., less issuance from Treasury) and tossed out what he called a “fring-y” hypothesis, whereby Beijing finally tires of persistent yuan strength and decides to intervene with a bid for USD assets.
The overarching point is just that everyone is on the same side of the boat. And stretched positioning is prone to tipping over.
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