More pain likely for hedge funds as leveraged investors unwind wrong-way bond market bets, traders say

By Vivien Lou Chen

 

There’s likely more pain coming for hedge funds, the heavily leveraged investors which are incurring significant losses from wrong-way positions on the direction of interest rates in the U.S. and across the world, traders say.

Some hedge funds had expected major central banks like the Bank of England and Federal Reserve to turn hawkish on monetary policy given persistent inflation pressures and were caught off guard in the past week by unanticipated dovish pivots, as well as by the flattening of bond-market yield curves. Leveraged players are continuing to unwind their positions, with no let-up in sight, according to traders.

The continued need of hedge funds to short-cover, or buy back securities to close out open short positions, is said to be one of the contributing factors behind Tuesday’s decline in U.S. Treasury yields across the curve. Meanwhile, bond-market yield curves flattened in the U.S., U.K., Germany, Italy, France, and Australia, according to Tradeweb data, resuming a pattern that sometimes points to economic trouble.

“We’re just starting to hear about losses for hedge funds now,” said David Petrosinelli, a senior trader at InspereX in New York. “But the unwinds are starting from a large net-short position, which needs to be covered with purchases of the 10-year Treasury, so I think there is more pain coming.”

ExodusPoint Capital Management and Balyasny Asset Management are two hedge funds that have reportedly nursed losses, according to the Wall Street Journal. Two more are said to be Rokos Capital Management and Alphadyne Asset Management, Bloomberg News reported. Representatives of the firms couldn’t immediately be reached.

Read: Government-bond swings burn Wall Street investors

Tuesday’s fall in yields across the board on Tuesday sent the 10-year BX:TMUBMUSD10Y down to as low as 1.41%, or its lowest level since September, as traders brushed aside data showing U.S. wholesale prices surged in October.

Wednesday brings the U.S. consumer price index report, which is expected to come in toward 6%, or possibly the highest levels in more than 30 years. But more evidence of persistent inflation isn’t likely to deter the current momentum in the market, which has been confounded by the central banks’ dovish policy pivots, traders say.

Last week, the Reserve Bank of Australia, Federal Reserve and Bank of England all “defied market expectations on rate hikes,” said David Gagnon, managing director of U.S. Treasury trading at Academy Securities in San Diego, California. In the U.S., the policy-setting Federal Open Market Committee “threaded the needle with comments that interest rate hikes will depend on COVID-adjusted employment,” and bond investors “were caught off guard.”

Traders were described as still stunned by the Bank of England’s Nov. 4 decision to hold off on a widely expected interest-rate hike, which earned Governor Andrew Bailey the unflattering label of “unreliable boyfriend” which was first applied to former BOE Governor Mark Carney in 2018. The BoE’s decision followed Federal Reserve Chairman Jerome Powell’s Nov. 3 remarks on remaining patient about lifting interest rates.

One trader described bond markets as “turned upside down,” with less certainty around the best ways to position on interest rates anymore and a reduced reliance on economic data to guide them. What is being factored in by traders is a seemingly greater chance that Lael Brainard, known for a dovish view on interest rates, may become the next Fed chair.

Meanwhile, so-called real money players like asset managers and life insurers are continuing to scoop up Treasuries, traders said. That demand, coupled with hedge-funds’ short-covering and a reduced supply of Treasurys going forward, is leading to higher bond prices and falling yields.

Banks, which lend for the long term while paying interest to borrow in the short term, tend to get hit hard by flattening bond-market curves. Shares of JPMorgan Chase & Co. JPM, -0.76%, Citigroup Inc. C, -0.67%, and Wells Fargo & Co. WFC, -1.93% all fell Tuesday.

Real money buyers are still there and demand for fixed-income paper is still very, very strong,” said Gregory Faranello, head of U.S. rates at AmeriVet Securities in New York. “The only momentum that has come to push rates higher is from the levered community, even though many in it are trying to get out now, and that’s a theme that has been challenged time and again in 2021.

There’s a cloud hanging over central banks, which are caught between a rock and a hard place,” Faranello said via phone. “They’ve got inflation pressures they can’t ignore and are worried about labor-market losses. How that balances out is a real question mark.