Prepare for A Bond-Market Rally

Sometimes, you don’t want to hire the smartest guys in the room.

Former Salomon Brothers bond-trading chief John Meriwether thought he couldn’t go wrong when he tapped two Nobel Prize in Economics winners to be the brains behind his hedge fund, Long-Term Capital Management (LTCM), in 1994.

Myron Scholes and Robert Merton – who took home the Nobel Prize in economics for a complex, derivative-fueled equation known as the Black-Scholes Model – were certified eggheads.

Trouble was, they were a little too smart.

Scholes and Merton brought their derivatives expertise to LTCM – and, in order to juice returns from the fund’s $1.3 billion in assets under management, they used leverage like a pastry chef uses flour.

The fund built a quantitative model to determine the appropriate spread, or price difference, between similar assets, like, say, a 10-year U.S. Treasury and a similar Japanese bond. When these spreads moved outside of their usual range, LTCM backed up the truck, banking on the price gap returning to its normal range.

It worked – for a while.

LTCM posted a return of 43% in 1996. Strong performance begat additional investor interest, and by the end of 1997, LTCM had $5 billion under management. That’s when the trouble started…

Thanks to the wonders of leverage, LTCM controlled upwards of $120 billion in investments as of early 1998. That’s the hedge-fund equivalent of going 100 mph on a winding mountain road: There was no margin for error or the unexpected.

And success spawned another problem: other fund managers and investment banks started piling into the same trades, which pressured prices and made putting money to work more difficult. Around the middle of 1998, investment bank Salomon Brothers exited the risk-arbitrage business – selling positions that, as it happened, were similar to many of those held by LTCM, resulting in the fund taking some heavy losses.

Rather than pulling back, LTCM doubled down, increasing leverage from 25-to-1, to 50-to-1, anticipating that spreads would revert to the mean.

Then, in August 1998, Russia defaulted on some of its sovereign debt. Fixed income investors dumped risk assets, like emerging-market debt (a big LTCM holding) and bought U.S. Treasuries – which LTCM had heavily shorted.

The fund that had been viewed as too smart to fail had – thanks to its leverage – become too big to fail.

Fearful of a systemic financial crisis, the Federal Reserve Bank of New York organized a rescue plan for an orderly unwind of the fund. That triggered a rally in U.S. Treasuries.

Which brings us to today. Because right now, we’re seeing echoes of the LTCM scenario in the U.S. Treasury market…

Speculators, convinced that interest rates are headed higher, have been building short positions in 10-year U.S. Treasury futures. (That means that they’d benefit from a decline in the price of Treasuries.) The Federal Reserve, though, has signaled it’s close to being finished raising rates – if it’s not already done.

Once the Fed stops raising rates, the bulk of the gains from being short Treasuries will likely have been made. That means all those speculators piled into the same short idea have only one way out…. buying back in.

Too much leverage and too many investors piled into the same trade torpedoed LTCM. And those same factors might also sink a lot of investors today who are short U.S. government debt.

Speculators Are Doubling Down on Bearish Bond Bets

This is clear from the weekly Commitment of Traders (“COT”) report from the Commodity Futures Trading Commission (“CFTC”), which details non-commercial traders’ net positions.

(Non-commercial traders are speculators making one-way bets on an underlying commodity or financial index. In contrast, commercial traders take positions as a hedge against a business-related activity.)

What’s most interesting in the COT report is when positioning hits an extreme. And that’s where we are, as shown in the graph below of non-commercial traders’ positioning in 10-year U.S. Treasury futures…

As you can see, speculators are betting heavily – the second-largest short position since the CFTC began keeping records in 1992 – against the price of 10-year U.S. Treasuries. The current net short position is over 750,000 futures contracts (compared to last week’s record net short of 850,000 contracts). At the start of the year, the net short position was half as large.

The previous time this type of extreme happened was in September 2018. Speculators were also cautious about bond prices. They were worried about Fed rate hikes…

From December 2015 through September 2018, the federal funds rate jumped from 0% to 2.25%. Fed Chairman Jerome Powell said it would increase them another 25 basis points to 2.5% by the end of the year.

Non-commercial traders shorted Treasuries (when interest rates jump, bond yields rise – and bond prices fall), with the net position exceeding 756,000 contracts. But they overstayed their welcome.

After increasing rates by another 25 basis points in December 2018, the Fed took its foot off the brake. The next month, Powell said the central bank was no longer in a hurry to raise rates. By August, it had started cutting interest rates once more.

Now look at what happened to bond prices following Powell’s announcement…

The above chart of the Bloomberg U.S. Treasury Bond Total Return Index is made up of debt issued by the U.S. Treasury, with maturities ranging from 1 to 30 years. The index bottomed out in late 2018, as speculators had built a record short position. But a few months later, when investors realized the central bank was at the end of its rate-hike cycle, bond prices took off.

From the time speculator positioning in 10-year U.S. Treasury futures reached an extreme in September 2018, through September 2020, the Bloomberg U.S. Treasury Total Return Index jumped 20% (10% on an annualized basis). That’s a better return than the S&P 500’s historical 9.5% average – in a much safer investment – and, also, a better return than the Bloomberg U.S. Treasury Bond Total Return Index’s 6.4% average.

Shorts Must Be Bought Back

History might not repeat – but it often rhymes. Since March 2022, the Fed has raised interest rates from 0.25% to 5.25% – the fastest pace of any cycle since 1982. And based on the Fed’s most recent guidance, the cycle is about done.

Again, this has echoes of the LTCM situation…

Speculators aren’t buying that the Fed is almost finished hiking rates, as reflected by the extreme level of short positioning in bonds. When the Fed in fact is done, those same investors will need to buy back their positions and close their shorts. That means they’ll all rush for the exit at the same time.

Based on the way the scenario has played out in the past, 10-year U.S. Treasuries bond prices are headed higher. Those shorts have been a big part of the supply. Once they all bail, it means demand will increase with no one left to sell.

What’s the best way to play this? We recently highlighted two exchange-traded fund ideas where we see upside for investors with both a capital appreciation and income focus. Check out our recommendations here.

Scott Garliss

Porter & Co.
Stevenson, MD