Ominous signals for US with recession a real possibility as slowdown looms

Hedge funds are doubling down on their bets that the US yield curve will steepen, just as it flattens to within 20 basis points of inversion, historically a surefire indication that the economy is headed for a slowdown.

Whether slowdown morphs into recession, as every curve inversion in the past 45 years has reliably predicted, is almost irrelevant for those betting on the shape of the curve. What matters is they’re on the wrong side of the trade and losing money. Fast.

The latest Commodity Futures Trading Commission figures show hedge funds and speculators now hold a record net short position of 700,514 contracts in 10-year Treasury futures, and a short position of 97,333 contracts in two-year futures.

That is the second week in a row the difference between the two has been more than 600,000 contracts, an unprecedented gap since the tracking of CFTC positioning data started in 1995.

Just over a year ago, funds were flipped sharply the other way: net short two-year futures by about 255,000 contracts and net long 10-year futures by about 300,000 contracts, resulting in the biggest curve flattening position in a decade.

That ultimately paid off, and the curve is now its flattest and closest to inverting since 2007. Will funds have the patience to stick with their steepener bets now?

CFTC data show that the net short position in 10-year futures has swollen by 616,848 contracts so far in 2018, well on course for a calendar year record, while the two-year net short position has about halved.

But the 10-year yield has failed to hold above 3 per cent, and is now hovering around 2.8 to 2.85 per cent. The two-year yield, which is more sensitive to expectations of continued rate increases in the coming months, has largely held around 2.6 to 2.65 per cent.

BarclayHedge’s Global Macro Index is down 1.23 per cent so far this year, only behind Emerging Markets and Pacific Rim Equities as BarclayHedge’s worst-performing sub-index. The main hedge fund index is up only 1.11 per cent, but at least it’s up.

EurekaHedge’s global fixed income index is up 1.26 per cent so far this year, but other strategies in which Treasuries feature heavily are under water. The Macro Fund index is down 0.48 per cent year to date, the CTA/Managed Futures index is down 2.08 per cent, and the Trend Following index is down 4.5 per cent.

The shape of the curve and its signals continue to split market participants and policymakers alike, as highlighted in the minutes of the Fed’s latest policy meeting published last week.

“Several” participants noted the curve’s predictive powers and suggested policymakers pay “close attention” to the shape of the curve. Others believed “inferring economic causality from statistical correlations was not appropriate”.

Research published by the San Francisco Fed on Monday found “no clear evidence in the data that ‘this time is different’”, but stopped short of dismissing the warning signs flashed by the flattening curve completely.

“The recent evolution of the yield curve suggests that recession risk might be rising. Still, the flattening yield curve provides no sign of an impending recession,” the paper concluded.

Those on the wrong side of the yield curve trade might take some comfort from the fact that they’re not the worst-performing funds out there. BarclayHedge’s CTA Cryptocurrency Traders Index is down 42.45 per cent this year.