Short positions still in play for US treasuries

Despite last month’s significant price movements in US treasuries, yields are still below the levels seen at the end of last year.

Strategic bond fund managers who have taken high-profile short positions in US government bonds saw some of those moves pay off at the end of June as US treasuries suffered their largest one-week price falls for almost two years.

The yield on 10-year US treasuries rose from 2.95% to 3.22% in the week from 27 June to 1 July amid a wider improvement in risk appetite.

But while the move was significant, yields remain below the 3.3% level seen at the end of 2010, leaving plenty of room for manoeuvre – and anticipation of a further drop in prices.

“If we wriggle towards a diplomatic solution to the latest problems in Greece, the focus could switch back to the elephant in the room – which is the US,” said Old Mutual Asset Management’s Stewart Cowley. 

Negative duration

Cowley’s Dynamic Bond fund took a negative duration stance on US Treasuries at the start of 2011.

A more cautious approach at the start of July saw US government bond prices recover some ground last week, but most remain convinced of the merits of their short positions.

John Stopford, co-head of fixed income at Investec, said he increased his short position in US treasuries both in anticipation of and reaction to the jump in yields.

“We have added to our short treasury position, partly before and partly during last week’s activity” he said.

Stopford’s Strategic Bond fund is currently 1.5 years short in terms of treasury duration.

Richard Jeffrey, chief investment officer at Cazenove, said there remains the chance of a sell-off in bond markets.

“I think if you look at the upside potential versus downside risk, then you have to say bond markets look pretty fully valued, and the risk lies in a rise in yields.”

Refrain

That is a refrain bond managers have sounded for much of the year, particularly prior to the pushing out of rate rise expectations seen in the second quarter.

But even in an environment where interest rates are not expected to rise in the foreseeable future, those such as Stopford suggest improvements in the US economic outlook will prove supportive of his position.

Speaking ahead of the release of US non-farm payroll data on 8 July, Stopford said he viewed recent disappointing economic data points as a temporary occurence, adding such surprises tend to ultimately lead to mean-reversion.

“The risk/reward trade-off was attractive in terms of direction.

“We felt that was worth 50 basis points or so on the ten-year, which would take treasury yields back towards the mid-threes,” he said.

“We have probably done about half of that already, but there is still a way to go.”
Stopford admitted he does not expect US economic data “to turn on a sixpence” but said improved manufacturing and retail sales figures as well an “anecdotal evidence of a big jump in autoproduction over the next six months” as signs of an improving outlook.

The ongoing problem of the US debt ceiling, Stopford added, may be a “potentially catastrophic scenario”, and one he is hedging against.

“The only way to protect against that kind of potentially leftfield event is to put option positions in place. In the event of a large move in the market we are protected,” he said, acknowledging such an event may prove positive for his short position.

Raise the roof

Jeffrey believes the debt ceiling will be raised before the 2 August deadline, and also foresees the simultaneous introduction of other measures helpful to the US market, such as tax rulings to encourage repatriation of assets from overseas.

Surprises such as these would likely reinforce equity markets in the US – to the possible detriment of bond holdings.

But Jeffrey nonetheless cautions against “trying to double guess politicians.”
“It is impossible to be categorical over how these things will develop over the next few days, let alone the next few months. We watch and wait”, he said.

“Nobody is any good at timing”, added Cowley.

“Our short position has worked episodically, but things could start to get very disruptive for yields in future. We are one step closer to the end.”