By Jamie McGeever

ORLANDO FL (Reuters] – Hedge fund play on U.S. Treasuries and the dollar is a weathervane for investors risk appetite and overall economic outlook.

Chicago futures market data shows that they have built their longest long position in U.S. 10-year government notes in just four years, and their multibillion dollar bet on an even stronger greenback has grown to their biggest in the past 18 months.

This trade – which involves banking on lower long-term borrowing costs and a flatter yield curve, and a stronger dollar – indicates concern about future growth prospects. It also signals a strong desire to be safe or not worry over inflation. You could do all three.

The Commodity Futures Trading Commission data shows that hedge funds and speculators increased their long-term 10-year Treasuries holdings almost by 120,000 to 181,207, the highest level since October 2017.

This first look at how hedge funds have been reducing interest rate risk after the Federal Reserve’s September 22 policy meeting is available. It opens the possibility of a faster and more aggressive tightening than was previously expected.

The fund’s rush to purchase 10-year Treasuries totally reversed their saleoff prior to the meeting. This coincided alongside a deterioration in financial markets as investors faced the possibility that interest rates would rise next year.

The Fed’s hawkish stance led to more than twice the net short position of speculative accounts in Treasuries futures, which now stands at 62,829 contracts.

At this point, the bet isn’t paying off. This week, the 10-year yield leapt to 1.55%, up from 1.30% one day prior to the Fed’s policy declaration. Meanwhile, the yield curve for the two-year/10 year climbed steeply by 15 basis points, to 125bps.

However, the alarms are sounding. It saw its first drawdown of 5% in nearly a year, September was the largest monthly drop since March 2013. The climbed above 20, and U.S. sentiment reached a seven month low. This means that the near-term outlook for growth is dimming.

DOLLAR KING

It is this environment that favors bond, flat yield curves and dollar. At the end of it all, we can say that funds have won.

According to CFTC data, they have increased their net long-dollar holdings by nearly $2 billion to $15.3 trillion for the 11th consecutive week. It is their largest increase in net long dollar holdings since March of last year.

Dollar strengthened against other currencies for the fourth consecutive week, hitting an 11-month high. The increase in short-term real yields, safer-haven demands, and a rise in ultra short-dated bills rates due to U.S. Debt Ceiling impasse boosted dollar strength.

In times of economic uncertainty and slowing growth, the dollar can often do well. This may seem counterintuitive on the surface, but the relative world between exchange rates shows that the dollar offers safety and liquidity.

Global growth is slowing in the U.S. According to economists, Barclays Note (LON) that despite renewed Covid-19 infections and ongoing supply limitations, a slowing of business investment is consistent.

The third quarter GDP tracker for the company closed at 3.4% last week, indicating further risks than their official forecast of 4.5%.

Inflation is the most pressing issue right now for investors. Is the Fed arguing that current high levels are temporary? Are there worsening, more long-lasting overshoots in store? What will the Fed do, and more importantly?

There are some important inflation expectations measures that offer a better perspective than all the hype about inflation.

Although the Fed has raised the breakeven inflation rate across the curve, it is still far below what they were at the beginning of the year. The price of inflation-protected Treasury bonds (or TIPS) has also fallen since that meeting.

Goldman Sachs’ (NYSE:) economists have raised their core PCE inflation forecasts for 2021 – which is the Fed preferred measure – to 4.25%, from 3.9%. Their end-year projections are for 2.00%, 2.15 and 2.20% in the next three years – this is not runaway inflation.

This outlook suggests that current prices will be temporary and is what hedge funds, speculators, and others seem to have bought into.