Active Bond Traders Have Never Been More Short Treasurys: Is A Squeeze Imminent?

Yesterday, when discussing Crispin Odey"s letter to clients and what appears to be his "Hail Mary" trade, we pointed out that according to his latest client letter, the billionaire hedge fund manager has effectively bet everything on a plunge in bond prices, with a whopping 135% net short in gilts and JGBs.

We noted that, in light of recent shifts mostly among the CTA and hedge fund crowd, he is hardly alone in his mega bearish outlook on bonds.

Sure enough, according to the latest JPMorgan survey (for the week through Oct. 2) the bank"s clients as a whole have dramatically soured on Treasuries, with 44% holding a short position relative to their benchmark, the most since 2006, or before the financial crisis, and up from 30 percent in the prior period. Among those who actively place bets, such as speculative accounts, a record 70% were short, while an unprecedented (and impossible) 0% responded that they were long: in other words, everyone is on the same side of the boat.

As Bloomberg commented on the dramatic move, "the shift shows how a confluence of factors is weighing on the minds of bond traders as the fourth quarter begins. The Federal Reserve will start unwinding its balance sheet this month, and Chair Janet Yellen has signaled that stubbornly low inflation won’t deter policy makers from tightening. Meanwhile, in the betting markets, former Fed Governor Kevin Warsh, seen by some traders as having a more hawkish tilt, has the highest odds to succeed Yellen."

In the eyes of William O’Donnell at Citigroup Inc., the selling pressure may have only just begun.

“The crowd of longs between seven years and 30 years in U.S. rates is both heavy and also now slightly underwater,” with yields near or above their 2017 averages, O’Donnell, a strategist, wrote in a report Tuesday. “It leaves us thinking that any additional positioning stress via higher rates may one day turn a trickle of selling into a torrent of secondary market supply under the right conditions.”

Of course, with everyone "on the same side of the boat", a far likelier outcome is a massive squeeze as even the smallest deflationary event spark a scramble for the exits. One example, from the other side, can be seen in the week through Dec. 12, when 39% of clients were short, which at the time was the most since 2015. On Dec. 15, the benchmark 10-year yield reached 2.64%, the highest in more than two years. It hasn’t returned to that level. Subsequent record positions in early 2017 per CFTC Committment of Trader readings led to even bigger slides in Treasury yields, in turn leading to a near record long exposure just week later, only to lead to a move higher in yields.

Indeed as Bloomberg concedes, "at the moment, Treasuries don’t look like the screaming “sell” they did when 10-year yields approached 2% last month. Now at 2.34 percent, the yield is approaching the most oversold level in months, based on relative strength index analysis."

That leaves traders eyeing 2.42% , a high from May and also a key retracement level based on Fibonacci analysis.

“Short-term oversold conditions suggest that this support band should hold, at least initially,” O’Donnell said. But there’s “still more upside for yields and USD, which should keep bears’ hopes alive for a re-test of 2.60% before the end of the year.”

With few active traders left who can add to the short pile up, look for yields to glide lower once again as the next Tsy short squeeze materializes in the coming weeks.

Fed Trial Balloon: JPM Warns Fed May Start Shrinking Balance Sheet In September

It appears the Fed"s balance sheet "trial balloons" using primary dealers as intermediaries have begun.

After yesterday"s unexpectedly explicit guidance on the future of the Fed"s balance sheet, which prompted Goldman, Citi, and various other banks to suggest they may bring forward their estimates for when the Fed will announce the start of "renormalization", moments ago JPM"s Michael Feroli, traditionally the analysts "closest" to the Fed, did just that when he issued a report stating that that there is now "chance of a September start" to renormalization, with the values for monthly roll-off caps and phase-in period to be "revealed at the June FOMC meeting."

According to Feroli, JPM continues to look for normalization to commence at the December FOMC meeting but "there is some chance of a September start, though this would not have a material difference for our projections on a multi-year horizon. At the meeting at which normalization starts we expect the Committee to announce a set of monthly roll-off caps for the following year, which increase regularly every three months.

"Our best guess is that the initial caps are $4 billion a month for MBS and $8 billion a month for US Treasuries. In the preannounced schedule, these caps would be augmented each quarter by $4 billion and $8 billion, respectively, until at the end of the year they are $16 billion and $32 billion. Consistent with yesterday’s minutes, even after the normalization process is fully phased in the monthly caps will still be in place, though in most months after the full phase-in they would cease to bind."

And here are the finer details which the Fed may or may not have leaked to select banks, in an attempt to prepare for what is coming, and talking down the equity bubble:

The Committee has yet to communicate values for the monthly caps or the length of the phase-in period. Presumably they will do this in the minutes to the June FOMC meeting. It is less clear that the Committee will have decided on a monetary policy implementation framework by the time roll-off begins (i.e. the current ratesetting system vs reverting to the pre-2008 system) and hence whether they will have decided on an ultimate amount of excess reserves available when the balance sheet is fully normalized. We have assumed a $500 billion target for excess reserves in our projections below. The other key assumption on the liability side of the Fed’s balance sheet is currency growth, which we have penciled in at 4% per year.

Under these assumptions the balance sheet is fully normalized in late 2021 at a level close to $3.0 trillion, down from about $4.5 trillion now. After normalization the Fed would turn to become a net buyer of  Treasuries, at a pace of around $400 billion per year, partly to meet growing demand for currency and partly to replace MBS which will continue to roll off the balance sheet. During the normalization process we see the funds rate as the tool of first resort for adjusting policy to both economic strength and weakness, unless the funds rate returns to the effective lower bound around zero, at which point roll-offs would stop. This latter eventuality is a risk for normalization being completed later than we anticipate.

Mechanistic questions about the impact of this a Quantitative Tightening on asset prices aside (it will be very bearish as the market will realize soon), we remind reader what former Fed governor Kevin Warsh said about the Fed"s normalization "policy" several weeks ago.

I am confused by the Fed’s ‘normalization’ strategy in monetary policy. Its preferred sequencing of rate increases and balance sheet reductions differ markedly from what was agreed when we conceived QE in the ’war room’ amid the crisis. There might be good reason. But, the transmission mechanisms of rate changes and balance sheet adjustments are markedly different than projected. So too are the distributional effects. This merits a more robust public explanation.

Alas, a public explanation will not be provided.

Gary Cohn Is The Leading Candidate To Replace Janet Yellen: Beacon

Several months ago, when it was still conventional wisdom that Trump wanted to replace Janet Yellen - at least until Trump"s famous WSJ interview in which he flipped on this and various other issues - with a hawk once her tenure runs out in 2018, the financial punditry was busy coming up with potential replacement names, a practice which gradually faded away once it emerged that Trump may well keep Yellen.

That changed today when in a note by Beacon Policy Advisors, a new name emerged which according to CNBC has set Wall Street abuzz. That name is that of former Goldman COO and current Trump National Economic Council advisor Gary Cohn.

"The buzz among those who claim Cohn confides in them is that he would like to eventually replace" Yellen, assuming Trump decides to move in a different direction when the chair"s term ends in early February, Beacon Policy Advisors said in its daily report for clients Tuesday, cited by CNBC"s Jeff Cox.

"On paper, Cohn likely meets Trump"s expected top two requirements for a Fed chair candidate," the Beacon analysis said, specifically citing Cohn"s advocacy for deregulation and his likelihood to keep interest rates low as Trump seeks to implement his pro-growth economic policies.

As Cox notes, while during his presidential campaign Trump openly criticized Yellen, accusing her of keeping interest rates low and using monetary stimulus to prop up the economy under Obama, "he"s been relatively mum about Yellen since taking office in January. He also has emphasized the need for a cheap dollar and low interest rates as the economy seeks escape velocity from an extended period of low growth."

"If Trump wants rates to be as low as possible, (Yellen"s) still the best choice," said Greg Valliere, chief global strategist at Horizon Investments and a widely followed expert on the Wall Street-Washington connection. "In my career, I"ve never seen a president who favored higher interest rates. That"s pretty unusual."

To be sure, who better to do that than the former Goldman Sachs #2. In many ways it would be a logical progression: with Goldman alumni already in charge of many central banks, either directly or indirectly - former Goldman MD Bill Dudley runs the New York Fed, while former Goldmanites run the BOE and ECB - it would be perfectly fitting that Trump would complete his metamorphosis to an establishment politician by appointing a Goldman banker to run the Fed directly.

According to sources cited by CNBC Cohn is among the top contenders, along with former Fed Governor Kevin Warsh and FDIC Vice Chair Thomas Hoenig, to replace Yellen.

"He"s the leading contender," said Christopher Whalen, an insider in the banking world and currently head of Whalen Global Advisors. "Every Fed chairman in recent memory going back even to (Paul) Volcker went through the White House in one way or the other. ... It would certainly make sense." Whalen said he personally favors Warsh for the position but believes Cohn "wouldn"t be a bad choice." Whalen thinks Cohn would "have no choice" but to advocate for keeping rates low during what Whalen believes will be an economic slowdown ahead.

A White House spokeswoman said the chatter was "entirely speculation" and called the Beacon report and any others "inaccurate."

Cox notes that there are several negative considerations to picking Cohn.

Most notably, the president is relying on Cohn to usher his economic agenda through Congress and help with the implementation, particularly regarding tax reform. If Trump can"t get a tax plan passed by next February, that would make it tougher to let go of Cohn. Moreover, CNBC recently reported that Cohn actually may have pushed Trump to keep Yellen on board. However, it"s not clear whether Yellen, 70, even would want to be given another them.

Should Yellen would want to leave, however, Cohn, along with Hoenig, Warsh and John Taylor, "would certainly be on the short list," Valliere said. "Cohn would be an interesting pick, though there would be some concern that he was politicized and the markets could view him with some suspicion that he is too close a political ally with Trump."

Then there"s the obvious Goldman connection. While Cox correctly notes that Critics "have ripped into Trump for perpetuating the "Government Sachs" culture in Washington where so many of the firm"s principals have found their way into high levels of government" that does not appear to be bothering Trump much in recent weeks.

Beacon concluded that "it remains unclear though, especially this many months in advance of Yellen"s term ending, as to whether there will be sufficient support for Cohn for this role within the West Wing at that time and whether he could even get confirmed given his lack of conservative credentials and academic background, not to mention his prominent ties to Goldman Sachs."

However, the fact that this particular trial balloon is being floated so early to set the stage, likely implies that the probability of a former Goldman president becoming Fed chair is far higher than most would suspect.