One question that has emerged recently on trading desks is what will happen first: Bitcoin hits $20,000 or the 10Y rises above 1.0%. The answer may depend on what bond-trading CTAs do.
As Nomura quant Masanari Takada writes when commenting on yesterday’s spike in 10Y yield which rose as high as 0.96%, “CTAs have resumed preemptive exits from long positions in UST futures.” Noting that at the same time as momentum-chasing CTAs have been gradually adding to their exposure in DJIA and Russell 2000 futures …
… CTAs are being drawn back into exiting long positions in 10yr UST futures (TY). As 10yr yields bounced back up to around 0.95% this week, “CTAs, who had been waiting on the sidelines, have again been pressed into action” with the Nomura quant estimating that CTAs have already liquidated about 65% of the long TY positions they held at the peak in August, and with a key trigger line at around 1.02% on the near horizon, CTAs are looking increasingly likely to have to exit the entirety of their aggregate net long TY position.
Should 10yr yields break above 1.02%, CTAs would be pushed “en masse” into loss-cutting mode, and the resulting systematic sell-off would put additional upward pressure on yields. According to Takada, based on past correlations “the 10yr UST yield could jump up to around 1.20% if CTAs were to sell their way down to a flat position.“
While any systematic selloff would likely lead to buying by other investor types, Takada cautions that UST bulls would probably would probably encounter a pair of headwinds, the first of which is that risk-parity funds have little room in which to go any further with their buying of bonds driven by the decline in DM government bond market volatility. The reason for this is that the portfolio weight that risk-parity funds have assigned to low-risk bonds has already hit a ceiling (as a reminder 60/40 portfolios have been pivoting away from bonds for the “40” component of the basket amid fears upside is now largely capped). Also, demand for 1-m options on UST futures is tilted solidly to the put side, which is an indication that traders picturing a decline in prices for 10yr UST futures (TY) and a rise in volatility are in the majority.
The second, and even bigger headwind UST bulls would face, is that top-down investors—global macro hedge funds chief among them—are now finding themselves in the position of having to decide whether to turn around and get on board a rapidly emerging reflation trade. According to Nomura, global macro hedge funds are currently slightly to the long side in the UST market, but the nominal 10yr yield is now experiencing upward pressure, as if being pulled up by the swift rise in implied inflation expectations.
In parallel with the rise in expected inflation, US markets are the scene of a jump in buying of TIPS through ETFs. Inflows from US individual investors regaining their bullishness is likely one force driving the TIPS market up, which in turn is pushing breakevens to multi-year highs.
In summary, no matter the underlying thesis, Takada writes that it increasingly looks like some risk-hungry US individual investors and trend-following CTAs are increasingly engaging in what looks like a reflation trade with optimism over the outlook for the global economy is one factor behind these supply-demand dynamics. If nothing else, the Nomura quant warns global macro hedge funds and any other top-down investors “considering buying USTs in contrarian fashion before the 10yr yield makes it up to 1.02% ought to think carefully about the risks and rewards.”