By Jamie McGeever

ORLANDO (Reuters) – Hedge funds appear to be right on the sidelines of seismic Treasuries moves that have driven short-term borrowing costs higher and intensified flattening pressures along the yield curve. This has pushed up the U.S. consensus interest rate outlook for 2022 even further.

The week ending February 8th showed that speculators had flipped into a net short position of two-year Treasuries, and reduced their short position in the 10 year space to the smallest level since October. Futures market data from the week shows this.

The latest Commodity Futures Trading Commission Report reveals that bearish momentum is growing fast in 2-year futures. This is consistent with signs that bullish sentiment is developing in 10-year bonds.

This shows that funds have placed bets on the flattening of the 2s/10s yield curve.

CFTC 2-Year Treasuries – https://fingfx.thomsonreuters.com/gfx/mkt/gdvzynejepw/CFTC2Y.png

These data were for Tuesday February 8 through Wednesday Feb. 8. Two days earlier, figures from the CFTC showed that inflation rose to 7.5% in January. This was a forty-year record.

The result was a 24-basis-point increase in two-year yields. This is also the highest single-day gain since June 2009 and a 13-basis-point narrowing in spread between 10- and 2-year yields. It’s the fourth largest compression in a decade.

Now, the Federal Reserve will tighten their monetary policy by at least 150 basis points. The Federal Reserve began March with a 50 Bp rate rise. Wall Street banks are revising their Fed outlook significantly higher.

The first year in a row that hedge funds had been short 11430 two-year Treasuries contracts, this was the net shortfall for this year. Since October, the bearishest shift was seen in the week-on-week swings of approximately 59,000 contracts.

An asset’s value will drop if a short position is taken. A long position will be expected to rise if it is not. Bond yields increase when prices drop and decrease when they rise.

It was due to new shorts being opened and longs being closed that net short positions emerged. The strongest year-to-year momentum indicators point to the strength of the short side.

CFTC 2-Year Treasuries Short Momentum – https://fingfx.thomsonreuters.com/gfx/mkt/jnvwelzkovw/CFTC2YMOM.png

The CFTC data showed that the funds had reduced their 10-year U.S. short-term bond positions by 73,000 to approximately 202,000. This is its smallest decrease since October. New longs were opened almost exclusively, suggesting that there is a shift in the outlook.

That’s collectively a wager on higher 2-year yields and lower 10-year returns. The trend is rapidly accelerating, even though it has been there for months. Only 40 basis points separate the curve from inversion. This is the red flag which has preceded each of the six recessions over the past 45 year.

Recession in 2023/2024 will be a growing threat if Fed does not fulfill its promises for an aggressive tightening cycle within a quarter century.

“It’s widely acknowledged that the Fed over-stimulated, and was significantly behind the curve in the recent months. It doesn’t make sense to go the opposite way. Citirates strategists said that errors can be added to each other, but they don’t cancel one another.

US 2s/10s Yield Curve & Recessions -https://fingfx.thomsonreuters.com/gfx/mkt/zgpomjeyxpd/YCRECESSION.jpg

There may be other economic arguments as well. Two weeks ago, the 10-year-terms long positions of speculators were just 400,000, which is about half their total for almost five years. You can add with the offer of 2% yield.

And Russia could invade Ukraine. This would be a scenario where the largest and most secure market in the planet will likely draw strong investor demand.

The Macro strategy made profits in January, breaking the overall downtrend of the hedge funds industry. In February, fund managers will continue to be optimistic about higher short-term returns and flatter curves.

(These opinions are the views of the columnist at Reuters.

(By Jamie McGeever. Editing by Sam Holmes.