Hedge funds are positioned for higher bond yields and high equity indices according to research from Societe Generale’s Global Asset Allocation research team.
Hedge funds are net short almost every single US Treasury maturity compared to history. Using Z-Scores, hedge fund positions in the five and ten-year segments s are net short by around three times the standard deviation of their long-term averages since July 1998. This suggests some strong convictions that Treasury prices will fall further. SocGen points out that if this ‘belly’ end of the curve collapses, it is likely to lead to underperformance all across the curve.
Net short positions on ten-year US Treasuries are particularly negative, suggesting strong convictions that ten-year bond prices will fall and that yields will rise. Current short positioning shows a Z-score of -3, a particularly negative reading three standard deviations from the norm.
Hedge Funds Could Run Into Trouble
The question is, will this extreme positioning actually mark a turning point in long-term Treasury yields? There are past examples which show that it might. SocGen’s research team points out that a recent example of such a knee-jerk market move is July 2016, when hedge fund positioning on 30y T-bonds was exceptionally net long, and preceded a significant selloff in backend yields. At that time, the market focus on deflation fears was clearly exaggerated and coincided with a historical low in 30y bond yields. As shown in the chart below, there have been other occasions when extreme positioning has proceeded a move higher or lower in bonds.
However, the current level of short positioning “does not seem extreme enough to justify a call for an imminent drop in yields” according to SocGen.
This could be good news for hedge funds. Even though on average, funds are positive on the outlook for equities and short bonds, unchanged equity index levels, the rise of 10y Treasury yield to 3% would push the equity risk premium to very low levels, making equity very expensive versus bonds. Theory dictates that a smaller equity risk premium would justify lower stock indexes but this does not take into account any potential Trump stimulus. As SocGen explains:
“In the latest Risk Premium in Pictures: focusing on ‘g’, Praveen Singh and Roland Kaloyan analyse the combined impact of higher bond yields and a higher long-term growth rate (‘g’) on equity index targets. From a level of 8% in the early 1990s, ‘g’ came down 3% last year, but upgrades in nominal GDP growth (thanks to the Trump policies) should lead to a higher ‘g’. The analysis suggests the possibility of a new tailwind for equities. Particularly strong net long positions on US small caps would support that view.”
“A combination of a 10-year UST yield at 3% and a long-term growth rate ‘g’ at 4% could propel the S&P 500 to 2600. This is a simulation outcome, not an official target.”
