Back in January we laid out the "two most crowded trades" in the hedge fund community as we entered 2015. The first was being long the US dollar, a trade which as we updated two weeks ago has gotten so big, it is now the biggest consensus trade by a factor of 3x...
... one which when it finally does blow up, will wipe out many macro and micro "hedge" funds who have been frontrunning the Fed's rate hike since mid-2014, and the second Yellen hints at a rate cut or worse the shockwave from the USD liquidation will be felt around the globe.
For now, however, being long and strong the USD continues to be profitable in a world in which every other central bank is either desperate to crush their currency, like Europe and Japan, or even more desperate to boost it, like Nigeria, South Africa and Brazil.
What about the other massive consensus trade in early 2015? Here is what we said then:
For the second year in a row are not only massively short the 10Y, but in fact as the latest CFTC net spec data shows, are even shorter than they were a year ago, when the 10 Year was trading about 100 bps wider. Worse: as the chart below shows the only time in history when specs were shorter the 10Y was five years ago, in early 2010. What happened then was that the 10Y went from 4% to 2.5% in the span of just a few months, facilitated largely by one of the biggest short squeezes in 10 Year history.
The 10 Year is currently trading at 1.95%: a comparable short squeeze now to that that took place in 2010 would send the 10 Year yield crashing to level where the German Bund is trading now.
Will that happen, and how much more pain can hedge funds absorb before they get a collective tap on the shoulder, we don't know. We do know, however, that the unprecedented bearish sentiment toward 10Y US Treasuries among the speculative community makes it one of the two most crowded trades going into 2015.
Since then the 10Y rose, dropped, meandered around, and is set to exit 2015 precisely where it entered it: just about 2.2%.
One thing, however has changed.
From being the "other" biggest consensus trade 12 months ago, hedge funds have decided there is no longer a point in "not fighting the Fed" (which as a reminder has also been desperate to push the long end of the curve higher and has not only failed, but with the curve flattening dramatically, has been told by the market it's rate hike was a policy mistake) and have unwound their near record Treasury short position in droves.
As Bloomberg reports, confirming what we said nearly a year ago, "hedge-fund managers and other large speculators spent December 2014 setting the biggest bets against Treasuries in four years. Fast forward 12 months and they’ve abandoned those positions."
“As long as U.S. inflation is stable, there’s some value in buying U.S. Treasuries,” said Kazuaki Oh’E, the head of fixed income at CIBC World Markets Japan Inc. in Tokyo.
To be sure, the "value in buying US Treasurys" has nothing to do with stable inflation, and everything with frontrunning the recession and the Fed's inevitable rate cut and/or QE4 (and more foreign central bank buying), which in turn will send the long end soaring as then and only then will the curve flattening trade unwind and those long TSYs will scramble to rush into equities.
As Bloomberg further adds, "net short positions among futures traders -- bets against the market -- have been close to zero for the first two weeks of December, based on the latest data from the U.S. Commodity Futures Trading Commission. Shorts increased to as much as 261,282 on Dec. 30, 2014, the most since May 2010."
Meanwhile, never deterred by being wrong 5 years in a row in their forecasts for rising TSY yields, economists surveyed by Bloomberg project the 10-year yield will, once again, rise to 2.80% by the close of 2016, although even economists are starting to realize they can only lose so much credibility: at the start of July, the projection was for 3.3%.
Ironically, now that the short overhang in the treasury complex is that much smaller, and as a result the threat of dramatic short squeezes is far lower, 2016 may be the first year when there is indeed a jerk higher in long end yields.
That however, as Deutsche Bank explained a month ago in "How To Trade The Fed's Upcoming "Policy Error" In Three Parts" will be the first part of a multi-leg move lower in yields. What will follow this estimated blow out to as wide as 2.75% will be the buying phase, which will see the long end close 2016 at 2% if not less:
With all else equal, the market can decide to interpret rates selloff and Fed liftoff as policy mistakes and price in the adverse impact on growth and position for further rate cuts in the future. This is the third phase, the twist of the curve – the front end remains constrained by the Fed, while the back end rallies. It is a bull flattener, after a continued rise in rates. We anticipate the 10Y UST yield to rally towards 2% after trading as high as 2.75% during the second phase. This is generally bearish for USD and for risk assets, and as such could mean higher equity vol. Given that rates vol should reach high levels during the bear-steepening phase, bull flatteners would bring back vol sellers and return of the carry trade.
Of course, in a "market" manipulated beyond recognition (as BofA said earlier today), making any predictions is stupid, as such the best bet is to wait and see which side of the curve hedge funds congregate to as they inevitably will, and just do the opposite of what the crowd of "smartest people in the room" is doing, a trade which has been profitable for 7 years running.