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Losses for hedge funds betting big on the so-called reflation trade piled up in July, exacerbated by a dizzying rally in US government debt this summer that pushed Treasury yields to multi-month lows.
Graham Capital Management, Rokos Capital Management and Brevan Howard were among the funds hit, with Graham losing about 4.5 per cent in its $2.6bn Absolute Return fund in July, before recovering 0.8 per cent this month. Rokos lost 3.8 per cent last month, while Brevan Howard lost 3.9 per cent in a $1.2bn portfolio run by trader Alfredo Saitta.
The soured trades hinged on a view that higher growth and inflationary pressures from America’s emergence from the coronavirus pandemic would weigh heavily on longer-dated Treasury bonds, whose fixed payments erode in value over time in prolonged periods of rising consumer prices.
The US central bank’s pledge that it would disregard what it deemed “transitory” inflation — leading to an overshoot of its longstanding 2 per cent target — energised even bigger bets.
For a time, wagering against Treasuries and piling into so-called “steepener” trades, which profit when longer-dated Treasuries sell off at a faster pace than their short-term counterparts, delivered large gains to several big-name managers.
But the fall in 10-year bond yields to as low as 1.13 per cent in August from a peak in March of nearly 1.8 per cent peak has proven painful. While the benchmark bond yield has retraced some of that decline, increasing on Friday following the release of a strong jobs report for July, it remains well within its recent trading range, settling around 1.28 per cent.
The losses for hedge funds short Treasury debt began racking up significantly in June, following a surprising shift from the Federal Reserve that suggested a less tolerant view of higher inflation than previously thought.
Some investors were ultimately forced to cover their short positions, exacerbating the move higher in prices and the drop in yields. In the subsequent weeks, those losses deepened. Rokos, Brevan and Graham declined to comment.
The move lower in yields has confounded policymakers and investors alike, with Richard Clarida, vice-chair of the Fed, disclosing at an event on Wednesday that the sharp drop “surprised” him. Chair Jay Powell also recently admitted that there was not a “real consensus” as to what was moving markets, calling out investors who had pointed to “technical factors, which is where you put things that you can’t quite explain”.
Some market participants have argued that yields are lower because growth and inflation have already peaked for the year. That argument has been bolstered by the spread of the Delta coronavirus variant, which has hampered the reopening of economies across the globe.
Macroeconomic forces may not be the only thing driving the move in yields, other investors argue. The steady pace of declines untethered from data releases may suggest that the current move lower in yields is being driven by algorithmic traders, said Tom Graff, head of fixed income at Brown Advisory. Algorithmic traders may have taken their cues from the move lower in yields beginning in May and carried the momentum forward.
There may be more pain on the way for hedge funds in the reflation trade. Short positions in Treasuries are still elevated compared to levels seen in the first quarter, according to JPMorgan surveys of client positioning. In spite of recent losses, some funds are still holding out for higher yields to come.
There are several triggers that could break the cycle of low yields, said Eric Winograd, senior economist for fixed income at AllianceBernstein. News of a peak in Covid-19 cases, or evidence that the Delta variant will not create widespread economic damage could buoy faith in the strength of the economic rebound and the labour market recovery, paving the path for the Fed to begin scaling back its $120bn asset purchase programme.
“Yields are too low,” said Gerlof de Vrij, senior portfolio manager at Capstone Investment Advisors, a hedge fund. “The reflation story is still very much alive.”