Investors could be braced for the next so-called “painful” trade, as market participants increasingly coalesce around expectations that the Federal Reserve must act aggressively to combat persistent inflation in the United States.
As traders brace for a series of interest rate hikes this year, starting in March, many could be caught off guard in crowded bets designed to take advantage of expected monetary policy moves, if expectations based on the market suddenly changed.
Friday’s release of surprisingly strong January job gains lends more credence to a Fed rate hike next month that could be a bigger-than-usual increase of 0.50 percentage points, while the likelihood that the central bank’s key rate target could end the year between 1.75% and 2% also rose, according to the CME FedWatch Tool.
The problem is that the COVID-19 pandemic has split the spectrum of possible U.S. economic outcomes into two directions, which can change any day: one favors higher policy and market rates, while the Fed and other central banks are trying to tackle persistent inflation. . The other supports the view of lower rates, on the basis that economies are too fragile to withstand any significant tightening and that inflation should then run out of steam.
That leaves those positioned for higher US policy rates exposed to potential losses if the market narrative suddenly turns.
“Consensus views in this market scare me,” Gang Hu, a TIPS trader at New York-based hedge fund WinShore Capital Partners, wrote in a note after Friday’s jobs report. “Reading various street research papers, I found no one to disagree. But if we all agree and adopt the same positions, who will get us out of the job?
Friday’s strong nonfarm payrolls report was greeted by higher Treasury yields, as the 10-year rate TMUBMUSD10Y,
rose above 1.9%, stocks regained their footing and investors braced for a Fed that looks certain to move away from an easy money stance, which has kept fed funds pinned at current levels between 0% and 0.25%. Yet only a few months ago, some of the most sophisticated investors – hedge funds – were caught off guard by unexpected dovish pivots from the Fed and the Bank of England, as well as flattening yield curves. of the bond market.
Read: More pain likely for hedge funds as leveraged investors unwind bond market bets the wrong way, traders say
The unexpected nature of the pandemic has produced enough uncertainty to leave doubts about the outlook, Hu told MarketWatch by phone — starting with the possibilities that a new wave of COVID-19 cases could reappear at any time. and growth may decline. , bringing inflation down with it. His views were supported by a Treasury yield curve, or spread between short-term yields and their longer-term counterparts, which narrowed further on Friday, despite the surprisingly strong jobs report.
“We all follow central banks and take everything they tell us at face value,” he says. “But I think they could probably tell us something different some other time.”
Consolidations in the fund management industry heighten the risk ahead, with fewer people controlling more money, getting all the same information and making the same bets – with one financial company crossing the $10 trillion threshold, according to Hu. With so little oversight, “who has the size to be their counterparty and take them out of the trade?” he wrote.
Read: BlackRock now manages over $10 trillion in assets
The lack of suitably sized counterparties on the other side of a trade means that unwinding that position becomes more costly. “You can run, but if you’re forced to sell, exiting can be a painful adjustment,” said chief trader John Farawell at Roosevelt & Cross, a bond underwriter in New York.
Farawell pointed to Friday’s jobs report, which “shocked everyone”, as an example of how easily the herd can be wrong. “Now the question is whether the Fed is going to hike 25 or 50 basis points, and when I see everyone looking the same way, a painful trade can happen. With many positioned for curve flattening, it could now be steepening which will be the painful next step.
The difficulty of being on the wrong side of a popular bet was highlighted at the end of last year, when hedge funds suffered significant losses due to erroneous positions on the direction of interest rates in United States and around the world. Their need to cover short or repurchase securities to close open short positions was reportedly one of the factors contributing to lower Treasury yields in early November.
An absence of market players may occur in other markets, such as CL.1 crude oil,
leading to greater price fluctuations. The crude oil market has lost some players during the pandemic, especially companies that once acted as “circuit breakers”, said Tom Kloza, global head of energy analysis for the Oil Price Information Service. So several exploration and production companies have said they won’t hedge futures contracts, and “fewer participants translate to more volatility,” Kloza said.
Investors are now turning their attention to next Thursday’s Consumer Price Index report, which traders and economists expect an overall gain of around 7.2% year-over-year. . Traders also expect the February reading to come in at 7.4% and the March reading at 7.2% before the annual CPI begins to fall to 3.3% by year-end.
“There have certainly been binary ways of looking at inflation as it affects the market, but there hasn’t been as much dispersion of views as I would like,” said Rob Daly, Director of Fixed Income at Glenmede Investment Management in Philadelphia.
“The next painful trade could come if inflation moderates faster than expected and rates fall quickly, with the 10-year yield falling back to 1.50%, hurting those who have been positioned for aggressive rate hikes” , he said by telephone. . “Or it could come from inflation remaining sustainable and risk disappearing.”
— Myra P. Saefong contributed to this article