Going into last week’s Federal Reserve meeting, speculators increased their already record short positioning on U.S. Treasury bonds to a new record short position. Speculators and investors alike are betting ten-year Treasury yields are headed somewhere between 4-6%, yet they continue to run into an impenetrable wall that is preventing yields from rising past 3.1%. What they don’t realize is the impenetrable wall is the Federal Reserve.
When the Fed was running their Quantitative Easing programs, the purpose was to lower short-term interest rates by buying bonds. The Fed bought both short- and long-term U.S. Treasury bonds and Mortgage-Backed Securities. While many believe long-term rates fell during QE, they rose.
To stimulate the economy, the Fed was pushing borrowers to short-term interest rates, which were extremely low. There was still a demand for long-term bonds, as Americans were still financing long-term debt in the form of mortgages. Long-term debt needs to be backed by long-term bonds, so to attract capital as the Fed was vacuuming up every long-term bond in sight, long-term yields rose.
Starting in December 2016, the Fed began tightening or engaging in the opposite of QE, or Quantitative Tightening. As the Fed unloads its long-term bonds back into the hands of the public, there isn’t enough demand for long-term borrowing. The net result is that short-term interest rates should be rising, which they are, and long-term interest rates should be falling, but they aren’t. The only reason long-term rates aren’t falling is due to the record speculative short positioning on U.S. Treasuries.
The Fed is going to increase the amount of bonds they unwind from their balance sheet from $40 billion per month to $50 billion starting in October. This will continue to act as a massive headwind to the speculators who are convinced long-term yields must go higher.
Ultimately, these speculators will find themselves on the wrong side of the trade and will be forced to exit their short positions. When they do, the largest short-squeeze in the history of the U.S. Treasury market will send long-term yields plummeting.
As long as the Fed is tightening, speculators will have to commit an ever-larger amount of capital towards keeping long-term yields elevated. In the end, the speculators are doing battle with the most powerful monetary force in the world. It’s not a question of if long-term yields will fall, it’s a matter of when the speculators realize they aren’t going to win.