Global macro hedge funds appear to be maintaining a contrarian stance versus the market when it comes to positioning on government rates.
In recent weeks, managers have secured gains by taking long positions in the US and Europe thanks to a global decrease in both short- and long-term rates in fixed income markets. In the middle of July, US 10-year Treasuries were yielding 2.45 per cent, since when they have fallen to 2.16 per cent (at the time of writing). Lower yields arise when economies aren’t firing on all cylinders. Whilst the US economy has shown signs of improvement, the recovery has been a stuttering one.
As Lyxor shows in its latest research brief, through May and June global macro managers decreased their net long exposure to US bonds (as yields climbed from 2.15 to 2.41 in early June), from 20 per cent to approximately 8 per cent of their net assets. Since then, they have ticked up their net long exposure to just over 20 per cent, making gains of 0.8 per cent month-to-date and 5 per cent YTD.
At the same time, managers turned aggressively short on Europe, suggesting a degree of confidence in Europe’s economic recovery. From end of April through to 10 June, German 10-year bunds climbed from a low of just 0.08 per cent to 0.98 per cent.
“Managers considered German sovereign bonds to be largely overvalued as 10-year bund yields fell close to zero. As they started to rise through May they made a decent return on this trade.Their current net exposure to European rates is neutral as they consider bunds to be fairly valued at the current level,” explains Philippe Ferreira (pictured), Head of Research, Managed Account Platform, Lyxor Asset Management.
Since the start of the year, global macro managers have been holding net short exposures of between -20 and -40 per cent on European bonds in anticipation of a better recovery in Europe than was being discounted by the market. By contrast, managers have expected the US recovery to be softer than was being discounted by the market. As such, they have maintained a broadly long position on US bonds, indicative of a bearish stance on the recovery; or at least a belief that the recovery was below market expectations.
This has proven to be the case as US 10-year yields have failed to break through the 2.40 barrier.
“The prospects that the Fed will introduce a rate hike towards the end of the year should mean that prices start to fall and yields will go higher. If global macro managers anticipate that the recovery will be strong enough to cause the Fed to introduce the rate hike before the end of the year they would start to short US Treasuries as was the case in May in Europe; but we’re not seeing any signs of this yet,” confirms Ferreira.
That the Fed will introduce a rate hike is not up for debate; this is a known unknown. The unknown unknown is the extent of the rate hike. Ferreira thinks it will be mild; a soft tightening. “This is why managers are still somewhat long US Treasuries, whereas the market is more hawkish and expecting more,” he says.
Here in lies the contrarian view. The conviction among managers seems to be that the US recovery is not yet strong enough and that there is no indication that the Fed will turn hawkish.
Ferreira thinks that managers will take a broadly neutral stance on US rates by the end of the year but as with all investing, getting the timing right is a difficult task. No one can read the mind of the Fed. It could, without warning, turn hawkish and catch managers by surprise. A resultant flattening of the yield curve would signal a headwind for recovery.
“Right now, no one is yet taking a negative stance on US Treasuries because there are too many uncertainties over whether the Fed will change its tone; especially after the move from the PBOC, which devalued the renminbi. I would expect this long position to head closer to zero as we head closer to the first rate hike,” adds Ferreira.
By year-end, it is not inconceivable that managers will have a broadly neutral net exposure on US and European rates. The question is, in 2016, might those two lines bisect one another as managers turn more bullish on the US recovery and remain cautious on Europe?
“If that were to happen it would reflect a rational expectation of economic growth potential in the two regions,” responds Ferreira. “We’ve seen the US leading the recovery ahead of Europe so according to that view, managers should be long European bonds and short US bonds. But their positioning is not in absolute terms versus the reality of how the market is being priced.
“The market has somewhat jumped the gun and has expected a faster recovery and macro managers, quite simply, have taken a more contrarian view; that the recovery would be better than expected in Europe and slower than expected in the US.
“I actually think we may continue to see that position; less aggressively long US Treasuries and some short positioning in Europe – as we saw earlier in 2015 – towards the end of the year as a result of the European recovery, which is not yet being discounted by the market.”
