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Orlando, Florida — Before the Fed’s policy meeting last week, hedge funds sold Treasuries, positioned for a steeper 2s/10s yield curve, and increased their bullish bets on the dollar.

Going by markets’ initial reaction to the Fed’s hawkish turn, the combination play was perfectly timed. The question now is whether this really is the beginning of a sustained move up in yields and steepening of the curve, or yet another false dawn.

Data from the Commodity Futures Trading Commission show that hedge funds and speculators in the week to September 21 cut their net long 10-year Treasuries holdings by more than half and added to their net short position in the two-year bonds.

They reduced their net long 10-year holdings by 68,202 contracts to 61,221. This followed a large swing the other way the week before, and came just before the Fed indication that it will start tapering its bond purchases “soon” triggered a jump in yields and rise in bond market volatility.

At the same time, they were net sellers of a much more modest 5,768 contracts in the two-year space to increase their net short position to 30,401 contracts. This bet on a “bear steepening” of the curve, driven by more aggressive selling of the longer-dated issue, looks to be in the money.

The curve steepened by more than 10 basis points the day after the Fed meeting, the most in 18 months and one of the biggest steepening moves in years. At 118 basis points, the curve is now its steepest in two-and-a-half months.

Supply constraints are pushing inflation and inflation expectations higher, which is moving some Fed officials to entertain the prospect of interest rates rising as early as next year.

If these supply side pressures are compounded by demand side impulses, yields could continue rising and the curve may steepen further. Certainly, the short-term momentum looks to be upward, with the 10-year yield finally breaking above the recent top around 1.38%.

Strategists at Citi say the curve will continue to steepen in the near term as investors build in more term premium into the longer end. Ten-year Treasuries may also be vulnerable to an asset allocation shift seeking a year-end equity rally.

But there remains a high degree of uncertainty on how the economy will stand up to the Delta variant, a relative tightening of fiscal policy, the Fed winding down its bond purchases, China-fuelled global growth worries, and ultimately the rise in yields itself.

The Fed cut its 2021 GDP growth forecast to 5.9% from 7.0% in June, and growth next year is expected to slow further. It is not the consensus view just now, but these factors could put a brake on the rise in longer-dated yields and flatten the curve.

Whether yields continue rising, the curve steepens or flattens, or the market is in “risk on” or “risk off” mode, the dollar is attracting buyers.

Hedge funds extended their net long dollar holdings for a 10th week, and at $13.45bn it is the largest since March last year. The dollar hit a one-month peak against a basket of currencies last week, and is a whisker away from printing new highs for the year.

But funds will be well aware that the volatility they thrive on remains stubbornly elusive in foreign exchange. Implied one-month euro/dollar volatility slid to 4.338% on Friday, the lowest since February last year just before the pandemic struck.

This points to relatively benign market conditions and rangebound trading. If so, the near-term upside to funds’ bullish bets on the dollar may be limited.



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