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When The Levee Breaks

Fund manager allocations to longer-term bonds are at a multi-decade high. For good reason — after starving in the lands of low interest rates for as long as anyone cares remember, you can’t blame investors for flocking to the yields now on offer. On the other hand, hedge funds have never been more bearish and are positioned decidedly the other way.

Part of the reason the so-called ‘smart money’ is betting on higher long-term interest rates has to do with the inflation picture: it looks rather murky. The pivot may be in for now, but it’s higher for longer and rising energy prices certainly isn’t helping. There are other economic forces also at play. Deficits are continuing to rise and there is a lot of debt that needs to be refinanced. That’s a rather large amount of supply coming to the markets, which will have an impact on pricing for years to come.

The difference between long- and short-term government bond yields is negative by about 1%. That doesn’t happen very often and is usually a harbinger of gloom and doom. The base case is still that the economy tanks, rates will have to fall commensurately, and long live duration. In the end, who is right or wrong may not matter all that much. With such a large allocation mismatch, even the smallest changes to positioning can lead to extreme price momentum as the losing side scrambles for cover.


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