Reflation trade unwind wrongfoots several big-name hedge funds

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Investors are reassessing their conviction in the reflation trade that has captivated Wall Street this year after a hawkish tilt by the US central bank inflicted losses on some fund managers.

Betting against the price of US government bonds was a winning play earlier this year, with hedge funds and other investors raking in sizeable gains as the economic recovery gathered pace. But recent gyrations and the spectre of a policy pivot from the Federal Reserve have heaped significant doubt on whether investors should remain in the trade.

“It is obvious that the reflation trade got rinsed,” said Thanos Bardas, deputy chief investment officer for fixed income at Neuberger Berman. “The market overreacted, [but] the uncertainty has increased.”

Several big-name hedge fund were caught up in the maelstrom, including Andrew Law’s Caxton Associates and Chris Rokos’s Rokos Capital.

The rationale for the reflation trade had centred around expectations that the accelerating US vaccination programme and removal of Covid-19 lockdown measures would usher in a period of high growth and inflation as business activity began to normalise.

The Fed’s insistence that it would also look past rapidly rising US consumer prices, which it deemed temporary, before adjusting its ultra-accommodative monetary policy further emboldened investors to take a stance against longer-dated Treasuries. Longer-term debt tends to suffer disproportionately from inflation since it erodes the value to investors of interest payments that are “fixed” for a period that spans many years.

Hedge funds piled in to the trade, betting that it was the next big win after they profited from rallying prices for US Treasuries last year. Caxton, one of the top-performing hedge funds in 2020, wrote in December that “the stage may well be set for a great reflation”. Some funds bet bond prices will fall, while others put on positions against the dollar.

Recent months have taken the shine off of this trade, with renewed buying in 10-year Treasuries sending yields falling well off of recent highs recorded in March 2021 despite larger than expected jumps in consumer prices. But it was June’s meeting of US central bankers and nascent signals that the Fed may not be as tolerant of higher inflation as previously expected under the new policy framework it unveiled last August that delivered the most significant blow to date. 

After initially selling off sharply after the meeting — which opened the door to two interest rate increases in 2023 — US government bond prices shot higher as investors grappled with how to decipher the Fed’s slightly less dovish tone. This rise in price pushed the benchmark 10-year yield as low as 1.35 per cent this month, from highs of nearly 1.8 per cent in March. It has since steadied at about 1.50 per cent.

The two-year note, which is more sensitive to monetary policy adjustments, shifted higher, with yields up 0.11 percentage points since the start of the month to 0.26 per cent. That led to a swift flattening of the yield curve, which tracks the difference between long and short-dated Treasury yields.

“What happened was a bit of a reinterpretation of what the Fed’s [framework] really means,” said Michael De Pass, global head of US government bond trading at Citadel. “The ‘let it run hot’ narrative is maybe not quite as pronounced as market participants were anticipating.”

Line chart of 2-year government notes (%) showing Fed policy shift signal pushes short-dated yields higher

He added: “Confidence in the [reflation trade] has been dented.”

The price swings were in part amplified by how funds were positioned heading into the Fed meeting. So-called “steepener” bets that profit when longer-dated Treasury prices decline at a faster pace than shorter-dated notes were particularly crowded ahead of the Fed meeting, according to CFTC data.

Caxton suffered a drop of about 8 per cent in its $2bn Macro fund, which is still up this year, said people who had seen the numbers.

Brevan Howard has lost roughly 1.5 per cent in its main fund in June and 2.9 per cent in a fund run by trader Alfredo Saitta. Rokos has lost about 4 per cent this month, according to people familiar with its performance. Rokos and Brevan declined to comment, while Caxton did not respond to a request for comment.

While some managers have been burnt by the reversal of the reflation trade, others are holding firm, using the recent “positioning washout” — as one trader put it — as a buying opportunity. 

“Nothing in our view has changed. We are all in on the reflation trade,” said Bob Michele, chief investment officer at JPMorgan Asset Management, who noted that his team added to its steepened bets in recent days. “We think there is a lot of growth and inflationary pressures that are building in the economy . . . [and] we are only halfway through the reopening domestically.”

Dan Ivascyn, group chief investment officer at Pimco, is also of the view that long-dated Treasury yields are likely to rise from here, given that inflation risk is “to the upside”. But he cautioned the path forward could be bumpy.

“You are in a period where valuations are much more stretched, [and] it takes less bad news to create the same amount of volatility,” said Ivascyn. “You want to keep checking your thinking.”

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