Thursday, November 16, 2023
- Benchmark 10-year Treasury yields have plunged over 50 basis points (bps) after briefly surpassing 5% in late October. Reduced longer-term debt auctions, cooling inflation, slowing economic activity, and rising expectations for an end to the Federal Reserve’s (Fed) rate hiking campaign contributed to the pullback.
- Yields are now trading below their 50-day moving average (dma), and a potential head and top shoulders top has formed. Technically, a close below 4.42% would break the neckline and leave 4.35% (prior highs/key Fibonacci retracement level) as the next key area of downside support.
- After forming a negative divergence from yields, the Relative Strength Index (RSI) has dropped back into bearish territory, raising the odds for the highs on the 10-year being set last month.
- Elevated short positions in 10-year Treasuries could trigger a short covering rally and/or increased volatility in the Treasury market.
This week’s cooling inflation data has supported the case for ending the Fed’s rate hiking campaign. October headline Consumer Price Index (CPI) decelerated from 3.7% to 3.2% annually, while core CPI—which excludes the often-volatile food and energy components—eased from 4.1% to 4.0%. Rate hike expectations disappeared following the news, while expectations for a rate cut were pulled forward to May. However, with inflation still running well above the Fed’s 2% target, it is too early for a victory lap, although the “trajectory is encouraging,” according to LPL Chief Economist Dr. Jeffrey Roach, who dug deeper into the CPI report in yesterday’s blog (Yields Plummeted on Benign Inflation Report | LPL Financial Research (lplresearch.com).
Another encouraging trajectory for equity markets can be found on the chart of 10-year Treasury yields, which pulled back through several areas of support following the CPI news. Yields are now trading back below their 50-dma for the first time since May, and a potential head and top shoulders formation has developed. The key word here is ‘potential’ as a close below 4.42% would be required to break the neckline. Additional downside support sets up at 4.35% (prior highs/key Fibonacci retracement level). From our perspective, a completed head and shoulders top formation followed by a break below 4.35% would significantly raise the odds of a top being set for 10-year yields.
The lower panel of the chart highlights RSI. This momentum oscillator measures the velocity of price action to determine trend strength, overbought and oversold conditions, and divergences. Over the last several weeks, RSI has generated a series of lower highs as yields continued to climb, creating a negative divergence indicative of fading upside momentum. Divergences often—but not always—overlap with major market tops and bottoms.
Short Squeeze Risk
The potential end to the uptrend in 10-year Treasury yields could be a significant problem for short positions (investors who are short Treasuries in anticipation of higher yields). According to the latest Commodity Futures Trading Commission (CFTC) data shown below, leveraged funds (typically hedge funds and other speculative asset managers) reported near-record net short positions in 10-year U.S. Treasuries. Asset managers, including institutional investors such as pension funds, endowments, mutual funds, and insurance companies are on the other side of the spectrum, holding long positions near record highs.
The Basis Trade
Part of the extremes in short Treasury positions can be explained by the ‘basis trade,’ an arbitrage strategy that profits from pricing discrepancies between the cash bond market and futures market (basically selling expensive bonds in one market to buy cheaper bonds in another market). So, while short positions are running historically high, many are likely hedged with corresponding long positions in the cash market. However, hedged does not mean risk-free, as the basis trade is subject to liquidity and leverage, with financing for these positions typically done via borrowing in the repo market. As shown in the second panel above, Secured Overnight Financing (SOFR) volume has climbed (in tandem with short positions) to record highs, highlighting the jump in overnight Treasury repo activity.
In the event of liquidity drying up, leveraged funds may be forced to unwind their positions, sparking a potential jump in Treasury market volatility that could snowball as funds race to the exit door. According to a recent Bank for International Settlements report on the topic, “The current build-up of leveraged short positions in US Treasury futures is a financial vulnerability worth monitoring because of the margin spirals it could potentially trigger,” while adding that “margin deleveraging, if disorderly, has the potential to dislocate core fixed income markets.” Source: Margin Leverage and Vulnerabilities in US Treasury Futures
Easing inflation and slowing economic activity have reset expectations for future Fed tightening. Both equity and fixed income markets have welcomed this news with consistent buying pressure this month. Treasury yields have pulled back sharply, and the 10-year has formed a potential head and shoulders top formation. A break below support at 4.35% would complete the formation and also take out support from the October 2022 highs—significantly raising the odds for the highs on the 10-year being set last month. Downside pressure in yields could be accelerated by the covering of historically high short positions among leveraged funds. Furthermore, in a liquidity event, the potential unwind of the basis trade could lead to elevated fixed income and equity market volatility.
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