By Jamie McGeever

ORLANDO FL (Reuters] – The U.S. Bond market saw its first quarter marked by unprecedented volatility and the worst performance for decades. Unfortunately, Hedge funds did poorly and they are hoping to improve in the second quarter.

U.S. futures markets positioning for the first week in the new quarter revealed that the funds were generally correct on short-dated rate and yield moves, but they didn’t expect the rise in 10-year yields.

There was mixed results in the relative trade between 2- and 10-year Treasuries as well as the closely watched yield curve “2s/10s”. But the curve flattening funds were aiming for did not come to pass until a very short time.

According to data from Commodity Futures Trading Commission, funds decreased their 10-year Treasuries net position by 113,682 to 362,875, but increased their two-year bond net position to 72,194 contract, up from 59,202.

This was in essence a betting on the 10 year yield falling and the 2 year yield rising.

In the week to April 5, 2.55% was achieved from 2.40%. The yield on the 10-year bond rose further, to 2.55%. It reached a record of 2.77% Monday. The week ended April 5th saw a jump of 30 basis points in cash yield to 2.60%.

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.

These CFTC position changes were a collective wager on a flatter “2s/10s” curve. After the curve inverted 8 basis points by April 4, it quickly climbed to +20bps a few short days later.

Q1 CURVE TRADE TRADES CRUSHED

Hedge funds tend to take long-term directional wagers, and they often profit from the rising volatility’s arbitrage opportunities. The second quarter ended with funds appearing to be at least partly right, but the first quarter proved to be extremely challenging in terms of their Treasuries wagers.

HFR, a provider of industry data, said Friday that its Relative Val Fixed Income-Sovereign Index suffered a loss of 2.66% for the quarter. This is the worst performance in two years. Its results are stark in comparison to its Macro Index’s 7.71% increase.

Comparing the shifts of CFTC Treasuries Futures Positioning in the January-March Period with U.S. Yields moves shows that funds were able to make directional bets on higher yields but failed on curve trades.

The fund increased their 10-year bond net position by nearly 265,000 contracts and their 2-year net position by 147,000 contract, in effect betting that the yield on the 10-year bonds would be higher than the yield on the 2-year.

The quarter saw a 7.3 percent increase in 10-year yields, with a corresponding increase of 83 bps for the 2-year yield. But, 160 bps was the highest quarterly gain in 40 years. This was the largest change since 2011, when the curve flattened at 77 bps.

It is now widely believed that the Fed plans to intensify its policy of tightening, resulting in a sharp increase in interest rates and a drastic reduction of its current balance sheet.

Where does this curve take us?

Citi analysts note that a substantial amount of easing has already been priced in U.S. money market from the anticipated peak in rates in second half next year. This suggests there is limited space for the curves to flatten.

Analysts at Morgan Stanley (NYSE:) They argue that the inverted yield curve is “here to stay”, without necessarily indicating a recession.

Funds will hope they’re on the right side of a clearly emerging trend in the fourth quarter.

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(The author is a columnist at Reuters.

(By Jamie McGeever. Edited by Andrea Ricci.