Hedge Funds Fuel Treasury Rally With Record Bet on 10-Year Debt

Date: Monday, August 28, 2006
Author: Ann Saphir & Elizabeth Stanton, Bloomberg.com

(Bloomberg) -- Hedge funds and other speculators are wagering more than ever on the rally in U.S. Treasuries.

Speculators at the Chicago Board of Trade own 347,559 more futures contracts betting that prices of 10-year Treasury notes will rise more than those that would profit from a decline in the benchmark government note. That amounts to an almost $35 billion gamble that the gains will continue.

The record amount, reported by the Commodities Futures Trading Commission, is a sign traders are convinced two-years of interest rate increases by the Federal Reserve are slowing growth enough to curb inflation. They're joining investors such as Bill Gross of Pacific Investment Management Co., who runs the world's largest bond fund, who grew more bullish during the two-month rally that has pushed 10-year note yields to five-month lows.

``There's clearly a growing camp of investors who feel the Fed's done and the next move is going to be an ease,'' Woody Jay, managing partner at Rock Ridge Advisors, which runs a $210 million bond hedge fund in Greenwich, Connecticut.

Yields on 10-year notes fell about 6 basis points, or 0.06 percentage point, to 4.78 percent last week, the lowest since March 28. The price of the 4 7/8 note due August 2016 rose 14/32, or $4.38 per $1,000 face value, to 100 23/32, according to bond broker Cantor Fitzgerald LP.

The price of futures contracts for 10-year notes for delivery in September rose 6/32 to 107 1/32 last week at the Chicago Board of Trade.

Commitment Report

Large speculative long positions, or bets prices will rise on 10-year notes, totaled 675,003 in the five days ended Aug. 22, the Washington-based commission said in its Commitments of Traders report. By contrast, the total speculative short positions, or wages on a decline, was 327,444.

Futures contracts are agreements to buy or sell a security at a specific date and price, allowing traders to capture a change in the value for a fraction of the cost of the asset.

Tudor Investment Corp., which manages $14.5 billion, and Citadel Investment Group, which oversees $12 billion, are among the hedge funds in the $4.5 trillion-a-day futures market that must report positions exceeding set thresholds to the government.

Investors are not only betting the Fed is done raising its target rate for overnight loans between banks but that the next step will be to reduce interest rates after the central bank left its target rate at 5.25 percent on Aug. 8.

``If you believe for instance that the economy's weakening, yet inflation is going to remain stubbornly high, you'll build in easing down the road,'' said Jay, who said his firm isn't among the 69 firms with long positions classified as non-commercials in the CFTC report.

Fed Perception

The 5.155 percent yield on Eurodollar futures maturing in June 2007 shows traders expect the Fed to cut rates by about a quarter percentage point by that date.

Eurodollar futures, which are tied to expectations for three-month U.S. interest rates, have historically averaged about 21 basis points higher than the overnight lending rate.

``People perceive the Fed's done, and rates aren't going to go up,'' said Burt Gutterman, chief executive of Chicago-based Sangamon Trading, a commodity trading adviser that buys and sells futures contracts on assets from soybeans to Treasuries.

Any trader holding more than 2,000 10-year note futures, worth $200 million, must report holdings in all commodities. Goldman, Sachs & Co., Deutsche Bank Securities Inc., UBS Securities LLC and Chicago-based Ronin Capital LLC are among the firms that exceeded that threshold this year, according to reports from the Chicago Board of Trade.

Hedgers

The traders must also disclose whether they are using the contracts to make bets on swings in underlying assets, or to guard against such changes. Those using futures contracts to make bets are designated ``non-commercials'' or speculators, a category that typically includes hedge funds.

``Commercials'' or hedgers, typically include bond fund managers such as Newport Beach, California-based Pimco, who use futures contracts to replicate strategies in the underlying bond market.

Pimco's Gross, who runs the $93 billion Total Return Fund, said earlier this month that the Fed is done because U.S. growth will slow. Pimco has added Treasuries and agency debt from government-chartered agencies the past two months.

Short positions by so-called hedgers also climbed to a record 1,483,259 contracts in the five-days ended Aug. 22, according to the CFTC. That may suggest prices are poised to fall, said Greg Blaha, a research analyst at Bianco Research LLC in Chicago.

The largest net long position on record before this month -- 183,000 contracts on March 17 -- was followed by a half-point increase in the 10-year note's yield over the next two months, and a collapse in speculators' net long position to zero.

Traders are still continuing to place bets on the side of the hedge funds even with yields at five-month lows.

``We've had a 45 basis-point rally in 10-year notes'' since June, said David Ader, head of U.S. government bond strategy in Greenwich at primary dealer RBS Greenwich Capital. ``You don't sell into that type of move. You want to join in.''

To contact the reporter on this story: Ann Saphir in Chicago at asaphir@bloomberg.net ; Elizabeth Stanton in New York at estanton@bloomberg.net