The Market's Next Big Pain Trade

Authored by Ven Ram, Bloomberg cross-asset strategist,

Extreme Bond-Market Positioning Heralds Pain Trade

Disappointments are the deepest when just about everyone in the markets is positioned for the same outcome.

With the disinflationary narrative in the US evolving in line with the Fed’s estimates, traders are bracing for that definitive inflection point in the economy that will send Treasuries soaring. 

In fact, traders are clamoring for bonds relative to stocks at a pace close to the fastest in two decades, possibly setting a low bar for disappointment - and potentially making it the markets’ next big pain trade.

Options on longer-maturity Treasuries show that outstanding open positions that will benefit from a rally are almost 2.5 times as much as those that offer downside protection, hovering around a peak set in September.

In contrast, positions that will gain from a slump in equities are twice as much as those that seek upside, a sign that traders are braced for a correction after this year’s melt-up in stock valuations.

The lopsided positioning means that bond bullishness relative to stocks is near the highest in data going back to 2005, a reflection of conviction that an inflection point in the US economy is around the corner.

The extreme optimism toward bonds relative to stocks isn’t completely without merit.

Headline inflation that was running at 6.5% at the end of last year has since halved. Core PCE, the Federal Reserve’s preferred gauge, is now at 3.5% — less than the Fed’s year-end estimate of 3.7%.

That progress in the battle against inflation has spurred bets that the Fed will slash its benchmark rate by as much as 125 basis points by the end of 2024, which isn’t an implausible scenario.

While Chair Jerome Powell pushed back on suggestions of a premature policy easing last week, current rates may seem too restrictive should the disinflationary process become more deeply embedded in the economy.

That is as good as it gets for the current bond-market positioning.

Arguing against such bets are the US economy’s relative resilience and several credible estimates that the neutral rate may have reset higher in the aftermath of the pandemic.

It’s no secret that the economy has fared far better than policymakers estimated. The Fed, which forecast economic growth of just 0.5% for 2023 around this time last year, has since revised up its estimate to 2.1%. For next year, it projects growth of 1.5%, which would be below its own estimate of long-term trend growth of 1.8%. It also reckons that the jobless rate needs to climb from 3.9% now to 4.1% to bring the labor market into balance.

Prospects of a higher neutral rate will also deter the Fed from loosening policy too quickly. The Fed’s own researchers reckon that the rate — a nirvana policy setting doesn’t boost inflation while keeping the labor market going — has shifted higher.

Against this backdrop, the rally in Treasuries that has sent 10-year yields plunging by some 75 basis points from a cyclical peak of 5.02% looks to have gone too quick and too far.

The overwhelmingly skewed positioning in the markets read against a backdrop of a still-resilient economy suggests that traders’ high conviction has the potential to become the next big pain trade for the markets.