By Jamie McGeever

ORLANDO (Reuters) – Hedge funds entered the Fed’s interest-rate lift-off betting on a stronger dollar with a steeper U.S yield curve. However, they have been proven wrong as the dollar has since dropped slightly, and the curve has flattened significantly.

The week ending March 15th, the day prior to the rise in U.S. rates from 2018, revealed that the biggest increase in net long-dollar positions by speculators this year was shown by futures market data.

Also, the data revealed that the two-year Treasuries futures had the greatest shift in favor in more than a year. It also saw a net position reduction twice as drastic as the scale back in funds’ net short position for 10-year bonds.

This was basically a wager that the yield on the 2-year and 10-year bonds would fall more quickly than those of the 10-year bond, thus’steepening the curve’. However, the reverse happened.

Following the Fed’s rate increase, the difference between Treasury yields on two and 10 years shrank by about 13 basis points to only 18 bps. The Fed’s rate hike is expected to cause an inversion. This has happened before every recession for the past 45-years.

The flattening yield curve was a bet that funds made in the early months of the year. They have been trying to place for a reversal in the last weeks, but this has not happened.

According to the latest Commodity Futures trading Commission, funds have reduced their two-year Treasuries net position by 92.3313 contracts. This is the largest weekly movement since February 2013. The net short position of the 10-year Treasuries was cut by 56 723 contracts.

Graphic: CFTC 2-Year Treasuries Weekly Change: https://fingfx.thomsonreuters.com/gfx/mkt/gkplgqmgyvb/CFTC2Y.png

Graphic: US Yield Curve &Recessions: https://fingfx.thomsonreuters.com/gfx/mkt/mypmnqmnrvr/YCRECESSIONS.jpg

An asset’s value will drop if a short position is taken. A long position will be taken if it rises. When prices fall, bonds yields will rise and then decline when prices rise.

Although the Federal Reserve raised its quarter percentage rate on March 16, it was not unexpected. However, policymakers made bold predictions about how fast and high they would have to raise rates to curb inflation.

Bank of America (NYSE) wrote Friday that the March FOMC meeting was surprising because of its hawkish tone and now shows a Fed which has caught up with the curve, recognising the gravity of the inflation/employment mismatch.”

These factors support a higher overall interest rate, as well as a flatter curve.

THE KING DOLLAR CROWN SLIPS

Also, the CFTC data show that they made a large bet on the strengthening dollar. The largest weekly rise in bullish dollars bets since November was almost $4 billion.

The dollar’s performance has been a struggle since the Fed. Because foreign currency traders are now convinced that maximum hawkishness about the U.S. interest rate outlook rests in the dollar, the dollar has dropped 0.5% against a basket currencies and close to 1% against euro

An in-depth analysis of the latest CFTC report reveals that the recent surge in net long dollars positions was driven by a historic euro selling wave.

The net euro longs fell by more than 40,000 contracts. This was the largest weekly swing against one currency since 2018, and fourth-largest ever.

The funds that liquidated long positions instead of opening short positions made the drilling even more difficult. The second-highest number of CFTC contracts since 1999 was 40,643, which saw the longs be slashed.

Graphic: CFTC Euro Position – Weekly Change: https://fingfx.thomsonreuters.com/gfx/mkt/zdpxojyomvx/CFTCEUR.png

Graphic: CFTC Net Dollar & Euro Positions: https://fingfx.thomsonreuters.com/gfx/mkt/mopanbmngva/NETUSD.jpg

The European Central Bank talks tough about inflation. Traders are pricing rate rises for later in the year. However, Russia’s-Ukraine War has dimmed the outlook on the economy and sentiment towards it.

The dollar could be on the verge of a rebound, however. Analysts from MUFG say that when the yield curve is flattened between 50 bps-zero, the dollar tends upwards, just as it was in March 1997 and January 2000, April 2005 and December 2005, April 2017 to August 2019 and April 2015 to August 2018.

“The dollar’s history is very good right now for the spread of the 2s/10s curve. They wrote that they didn’t anticipate the same magnitude of gains, but said dollar strength looked likely on Friday.

(These opinions are the views of the columnist, who is a journalist for Reuters.

(By Jamie McGeever; editing by Diane Craft)