The Big Short: Fund Managers Warn Of 'risky' Treasuries Trade Despite Rising Rate Environment

A JP Morgan Chase & Co survey on 2 October found 44% of clients had placed short positions in Treasuries against their benchmarks. This is the highest number since 2006, and a jump from 30% the previous week.

Since hitting a low for 2017 of 2.05% on 8 September, prior to the Fed's announcement of plans to begin its balance sheet reduction, 10-year Treasury yields have since risen to 2.32% as at 23 November.

This is close to the 2.4% yield barrier flagged by veteran bond investor Bill Gross as the threshold for a possible bear market in bonds (see graph below).

Furthermore, the yield on two-year Treasuries hit 1.55% on 16 October, the highest level since October 2008, after it was reported by Bloomberg that US President Donald Trump was favouring hawkish economist John Taylor as the next Federal Reserve chairman.

The drivers for such a high number of short positions are based on several factors. Current Fed chair Janet Yellen has already said low inflation will not put the central bank off raising rates, with traders forecasting a 77% chance of a rate hike in December.

Furthermore, Rory McPherson, head of investment strategy at Psigma Investment Management, noted an unemployment level of 4.2% - the lowest in this expansion phase - has put some pressure on inflation, which also points to a rising bond yield environment, while flat yield curves and tight credit spreads make bonds, in general, appear unattractive.

Crowded trade

However, despite expecting Treasury yields to rise further, McPherson said investors must always be cautious when there is "big short" interest in bonds.

On technical indicators, he said Treasuries appeared oversold and had already moved a long way this year, meaning investors piling into a short position were making a "very risky trade".

He said: "Every indicator is bond yields are too expensive and the direction of travel is up, but owning shorts is a risky way of doing it. If you are right you win handsomely, but if you are wrong you will have to cover yourself by using borrowed money to buy it back, which gets expensive.

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"It does not give you any diversification if you own equities, so we would prefer just not to own Treasuries instead of shorting them, as it doubles up your risk."

Meanwhile, Dan Kemp, CIO of EMEA at Morningstar Investment Management Europe, said the team is actually increasing its exposure to US government bonds in order to protect against some form of market crash.

The CIO said: "If you look across the US government bond index, it seems to imply a return that is more attractive than other government bond markets.