In May and June, speculative traders of Treasury futures were taking large short positions, believing that rates would move higher and the short positions would reap a profit. Since then, that net short position has increased by almost 50%, building to the largest short position—by a wide margin—in the history of the Treasury futures market.
When speculative traders initiate short positions, they hope that rates rise, leading to a potential profit (if the trader buys a futures contract in order to close out their short position and realize that profit). However, if rates move against these traders and fall from their current levels, the 10-year Treasury could be in for a “short squeeze,” when traders on the wrong side of a trade get squeezed into closing out their positions to limit losses. Traders in these contracts could see losses and buy Treasury futures contracts in an attempt to limit the damage, which would push prices up, weigh on yields and could lead to more traders buying futures to close out their positions.
As shown in the LPL Chart of the Day, massive short positions have generally led to declines in rates, and large long positions have generally led to increases in rates.
“Investors may intuitively hear about the record short position and believe that it may push rates higher,” notes John Lynch LPL Chief Investment Strategist, “but in reality, the opposite may occur, as traders closing out their positions could create downward pressure on yields.”
If a catalyst pushes yields meaningfully below 2.8%, the bottom of the range for the 10-year Treasury yield over the last six months, a short squeeze could push yields lower and fuel the snowball effect of a short squeeze. We estimate yields could fall 20 to 40 basis points (0.2% to 0.4%) as Treasury futures revert back to neutral positioning from current levels, based on historical rate moves during similar changes in positioning.
Even amid this extreme positioning, we maintain that the 10-year Treasury yield will end 2018 between 2.75% to 3.25%, reflecting stronger levels of growth and slowly increasing inflation levels.**
Futures and forward trading is speculative, includes a high degree of risk, and is not be suitable for all investors.
*Please note: The modern design of the S&P 500 stock index was first launched in 1957. Performance back to 1950 incorporates the performance of predecessor index, the S&P 90.
**Additional descriptions and disclosures are available in our publication Midyear Outlook 2018: The Plot Thickens.
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