Hedge funds and other speculators are making their biggest ever short-term bet on higher U.S. interest rates, a clear sign that the “vol-mageddon” bout of market turbulence earlier this month has almost completely fizzled out. Speculators are also slowly beginning to rebuild their bets on lower U.S. stock market volatility, according to the latest positioning data from the Chicago futures exchanges, potentially offering another source of support to risky assets globally.
How long the renewed sense of calm lasts remains to be seen. But the fast money investment community is quickly reverting to the “Goldilocks” scenario of solid U.S. economic growth gradually increasing inflationary pressures and the need for higher rates. All in a world of low market volatility.
World markets were thrown into a tailspin a few weeks ago when U.S. wage growth figures sparked fears that the Fed was behind the curve and would need to jack up borrowing costs far more aggressively than previously expected.
A record surge in volatility and $4 trillion plunge in world equity markets quickly followed. Ironically, this suddenly opened up the possibility that the Fed might delay or slow down its rate-hiking cycle.
The latest positioning data from the Chicago Board of Trade and Chicago Board Options Exchange show that rate expectations are firmly back on track. In fact, they were never really properly derailed in the first place.
The amount of speculative net short positions in Eurodollar futures rose to a record 3.65 million contracts in the week ended Feb. 20, according to the Commodity Futures Trading Commission.
That was an increase of more than 245,000 contracts from the previous week, the sixth straight weekly rise in net short positions. A further increase of just 41,934 in the next batch of figures will mean February will have recorded the biggest monthly shift ever towards bets on higher rates.
A short position on an asset is effectively a bet it will fall in price. In interest rate and bond markets, prices move inversely to yields, so a short position is essentially a bet on higher borrowing costs.
A rate hike at the conclusion of the Federal Reserve’s March 20-21 policy meeting is now a virtual certainty, according to money markets. This will be the sixth hike in the current cycle, with another two this year factored into market pricing. It will be Jerome Powell’s first policy meeting at the helm after replacing Janet Yellen as chairman earlier this month. Markets will get an insight into his thinking when he delivers semi-annual testimony before the House Financial Services Committee on Tuesday this week.
The latest CFTC data also showed that speculators continued to chip away at the record long position in VIX futures built up earlier this month when a shakeout in volatility derivatives triggered the biggest slide on Wall Street for six years. They reduced that net long position by 15,013 contracts in the week to Feb. 20, following a reduction of 11,255 contracts the week before. This brought the net long VIX futures position down to 59,550 contracts from a record high 85,818 on Feb. 6.
The VIX index of implied probability on the S&P 500 closed below 17 percent on Friday. That’s roughly the median level of the so-called Wall Street “fear index” since its inception nearly three decades ago. It spent much of the latter half of last year and January at record lows below 10 percent only to rocket above 50 percent on Feb. 5, the biggest one-day rise in its history.
As implied volatility has receded, so the S&P 500 has recovered. It’s up 8.5 percent from its Feb. 9. low, but still more than 4 percent off the market’s record high on Jan. 26. February’s hedge fund returns data aren’t out yet. They are expected to have derived a boost from the surge in volatility earlier in the month, in which case the year has got off to a pretty good start for hedge funds.
According to hedge fund database provider Eurekahedge, macro funds, Commodity Trading Advisors and managed futures funds all did well in January. These are accounts that are heavily involved in trading interest rate and volatility contracts. CTA/Managed Futures returns in January were 3.25 percent, the best month in three years) and macro funds returned 1.74 percent, the most since July 2009.