It's not just the Fed who is eager to push short-end rates higher while hopefully steepening the curve (so far it hasn't worked quite as planned judging by the biggest curve flattening in a decade): as a result of the sharp move higher in 2Y yields, momentum traders and CTA in general have joined the fray, and not just in equities, but on the Treasury curve.
As Bank of America's momentum team points out today, thanks to the historic performance in equities year-to-date, momentum strategies have been enjoying one of the best periods in recent years. And while not receiving as many headlines, there have been record trends in the rates market. And, as BofA shows in its Chart of the Day, the duration the 2y yield traded above its one-month moving average is the longest since February 1991.
The problem, now that momentum has crept into what has traditionally been a relatively boring, and directionless asset class, is that it is becoming difficult to determine just who is trading: quants or real money.
According to BofA, with the momentum in the rates market building across the curve, the balance of risks from a flow perspective has shifted to participants that follow momentum as opposed to those that focus on value. The bank's analysis suggests investors ranging from CTA strategies, convexity hedgers, to foreign private investors could all exacerbate the recent moves.
In short, if momentum traders were a headwind to a rates selloff in 2017, now they are a tailwind, and worse, they are already wreaking havoc for rates traders who have to consider not only the Fed and macro conditions, but the pile up in algos eager to keep the momentum going, potentially unleashing the next recession as they increasingly flatten the yield curve. And, as BofA warns, "the balance of risks is skewed to flows supports a continued move higher in yields."
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Some background from Bank of America on this substantial rotation of the key actors in rates trading:
First, the full-time trend followers
In several Treasury rally episodes in 2017, trend followers attracted considerable attention, being blamed for chasing momentum and exacerbating the rally; now the tide has turned. In a trending market like this, as shown in our Chart of the day, momentum traders likely already jumped on board the selloff and added to their net short positions. This is confirmed by two observations in the data for longer tenors as well.
While it is difficult to measure actual trend-follower positions, CFTC could be helpful. As we first mentioned last year, "non-reportable" net positions in CFTC data could be indicative of momentum traders' positions. The net position of this category has been tracking actual interest rate moves fairly consistently. And the continued selloffs in recent weeks gave confidence to these strategies to add to net shorts (Chart 1).
Chart 2 shows the rolling three-month correlation of daily changes in 10y yield and SG Trend index (one of the commonly referenced market indices for tracking performance of trend-following CTAs). Here, positive correlation indicates better fund performance coincided with higher yields. Since 1H17, this correlation has trended into negative territory and stayed negative for much of the year. Over the last two months, it has made a 180-degree turn.
Second, convexity hedgers are making a comeback, especially around 3pm each day
As rates continue to move higher, negative convexity MBS portfolios would see duration extension and trigger paying needs in the rates market. Convexity paying concerns are much smaller on an absolute basis compare to historical episodes (eg, 2003 and 2013), as a fraction of the MBS investors actively hedge duration. However, when these flows do emerge, they help sustain higher rates/wider swap spread momentum.
There may be signs of these flows in the market already. As many convexity hedging investors are considered formulaic driven and hedge duration at the end of the trading day, we show a three-day rolling average of swap rate changes after 3:00pm EST (Chart 3). Since the beginning of the rates backup last September, the market has been largely stable after 3:00pm except last week, a sign that investors resembling convexity hedgers were active during that time.
Finally, the threat that foreign private investors pick up the hint and join the coordinated selling.
Real money investors are also momentum traders, and this is particularly prominent among foreign private investors. During the 2013 taper tantrum and the 2016 post-US election period, when the rates market saw a sudden selloff, Japanese private investors followed along. In both episodes, there was a period of persistent net selling of foreign bonds by Japanese private investors that lasted at least three months (Chart 4).
More recently, as we have mentioned here and here, net selling pressure of US fixed income has increased as the yield pickup in currency-hedged US Treasuries fell consistently below European government bonds, and USD funding costs have become increasingly expensive as the Fed continued hiking. Although the latest data were updated only to November 2017, the slowdown in net purchase of US fixed income was clear (Chart 5).
In short, BofA's argument is simple: with the strengthening in momentum, risks grow exponentially that a further buildup in net short positioning could sustain a further selloff in rates.
The big question of course is how long before a potential selloff in 2Y rates overtakes the bearishness on the 10Y, and flattens the curve, eventually inverting it and officially starting the countdown to the next recession. All we can add here is that it would be ironic if algos, CTAs and momentum traders in TSYs are the catalyst for the next equity market crash, when it was the same algos, CTAs and momentum traders who - together with the Fed - were largely responsible for the market melt up over the past decade.
What we do know is that at this rate it won't take much to send the 2s10s negative.