Federal Reserve May Hold Rates as Bond Yields Spike

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With the inverted bond yield noticing upward shifts, hedge funds are excessively shorting U.S. treasury debt. So much so that The Bank for International Settlements (BIS) has warned financial markets that hedge funds could disrupt the U.S. Treasury market. Primarily because of the massive size of leveraged bets against it.

The $600 Bn short position against the $25 Tn U.S. Treasury market can cause problems in a couple ways. For one, because trading futures contracts is leverage intensive and, because of its very nature, can amplify losses, and also because of a damaging massive sell off due to impending losses similar to what occurred at the start of the 2020 pandemic.

The BIS also noted concerns regarding relative value trade, a strategy involving the comparative advantage between an asset’s current price and its futures price. Right now Treasury futures are trading at slightly more than the actual debt itself due to the fact that an initial margin on a futures contract, or up-front cash, is less than the cost of the underlying debt. Relative value trading, in this context, are massive purchases by hedge firms of underlying U.S. treasuries while simultaneously selling treasury futures. When the time to fulfill the contract comes, they can deliver on the actual security itself and pocket the difference.

This is occurring at a massive rate because of the nominal change between futures and treasuries. It is often financed by hedge funds using overnight borrowing on the money market.

A bond inversion occurs when the yield of short-term bonds is higher than that of long-term bonds. The yield is the return on original investment, but because coupon payments are typically fixed, this means that when bonds are resold on the secondary market, their price is inversely proportional to their yield. Water seeks its own level and it is the same with Newton’s Second Law of thermodynamics as well as the bond market. Bond yields increase with the Federal Reserve’s target rate hikes.

The bond yield inverts because investors are pessimistic about the near future. Bond yields increase with the Federal Reserve’s target rate hikes. With easy money policies through COVID between April 2020 to March 2022, and incremental tightening steps over the last year and a half (an upper limit of .25% in 2022 and stepped up to 5.5% in 2023) coupled with recession on the horizon, the yield curve is inverted and rates are rising across the board.

With the yield on some short-term bonds being currently higher than the Fed’s upper target of 5.5% currently, Federal Reserve officials are suggesting that the central bank may leave interest rates unchanged in the next meeting in three weeks.

Phillip Jefferson, vice chair of the Fed’s board stated on Monday in a speech to the National Association for Business Economics that he would “remain cognizant” of the higher bond rates and he also mentioned to “keep that in mind as I the future path of policy.”

This means that instead of another regulatory rate hike, the Federal Reserve may be able to use the rise in rates to slow inflation to its 2% target.

The Russo-Ukraine war and the Israel-Hamas war both have an influence on rising rates as well as our current soft landing that may prove to be fairly hard due to excessive speculation.