Trouble in Treasuries: Are hedge funds partly to blame?

On Monday of this week, the most important market in the world, to use the technical term, went completely bananas.

Treasuries have a habit of rallying when the going gets tough, which arguably happened when Silicon Valley Bank imploded. So the jump in US Treasury debt prices is logical against this background. The turmoil prompted jittery investors to seek safer hiding places.

The failure of SVB and other regional US banks suggests that the US Federal Reserve will be more lenient on interest rate hikes from now on, for fear of tripping up the banking sector. It could also mean that the central bank doesn’t have to be as aggressive as before when commercial banks tighten lending standards. Both factors would increase the attractiveness of bonds. In addition, many deposits yanked from banks ended up in American money market funds, where they were converted into treasury bills.

But there are bond rallies and there are bond rallies. This time, the market reaction to Treasuries was nothing short of apocalyptic. Two-year Treasury bonds, which are the most sensitive instrument in the debt market to interest rates, rose in price by leaps and bounds. Yields fell by a stunning 0.56 percentage points, after already falling by 0.31 percentage points the previous Friday.

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To put Monday’s move in context, it represents a bigger shake-up than March 2020 – not a vintage period for global markets. It was bigger than on any day of the 2008 financial crisis. You have to go back to Black Monday 1987 to find anything more serious. Trading volume is off the charts. It was Monday greatest day Around $1.5 billion changed hands, well above the $600 billion average.

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At the same time, other asset classes hardly beat themselves. Some US bank stocks, which had a strong whiff of technology, took a hit as expected. However, the S&P 500 benchmark index of US stocks closed largely flat. The picture is less clear but similar in Europe, where the Stoxx 600 closed around 2.4 percent lower on Wednesday — a decent bump but not a disaster — while two-year German debt yields fell at their fastest pace since. 1995

All of this shows that something strange is happening in the bond market. Christian Kopf, head of fixed income at Union Investment, blames the sector he used to work in: hedge funds. The Treasury market has become a “hall of mirrors,” filled with hedge funds that trade with the Fed.

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Macro hedge funds are flush with cash after the 2022 turmoil, when the economy bet on a rapid rate hike and won. They absorbed new money from investors willing to ignore the fees for a piece of the bargain. They show much more excitement in the market than traditional asset managers like Union Investment, says Kopf.

As Kevin McPartland, head of market structure research at Coalition Greenwich, says, it’s very difficult to quantify. “The data just doesn’t exist.” But the growing role of non-bank traders in the market is clear. Six years ago, banks trading with each other accounted for about 40 percent of the market, he says. It is now approaching 30 percent.

But the problem for hedge funds and other types of speculators this week was that, overall, they made roughly the same bets in 2023 as they did in 2022, positioned to win in an environment where the Fed is pushing for higher interest rates.

When SVB launched a search for safety in Treasuries, this bet paid off. When this happened, many hedge companies were forced to close their positions, effectively making them treasury buyers. This sparked more negative bets and forced more purchases. It was a classic short squeeze, and a big one at that. It left behind a string of big-name macro hedge funds that are suffering ugly losses. “The most important market in the world is dominated by a bunch of hedge funds,” says Kopf.

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Still, the lower yields make sense. The Fed will not ignore the SVB disaster. Neither is the European Central Bank, which has a bank scare with Credit Suisse on its doorstep. “These events could very well lead to a recession,” said Tiffany Wilding, North America economist at Pimco. The ECB has stuck to the script so far and decided to raise interest rates by half a percentage point this week. Still, it is reasonable to expect milder global growth from here on.

However, caution should be exercised before assuming that the bond market is throwing out reliable information about the next steps of the Fed and other central banks. A move in the market doesn’t necessarily mean that investors actually think interest rates are about to come down.

There is some irony here. One reason bond markets are more exposed to volatility now than a decade ago is that banks are much safer and less willing to take on risk, so hedge funds can fill the gap. But the past week shows that jitters over banks may continue to permeate the world’s most important market, and that the outsized role of hedge funds could make things worse.

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