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Big investors going short on the short end to play Fed hike

December 14, 2015 1:16 PM EST

The Federal Reserve building in Washington September 1, 2015. REUTERS/Kevin Lamarque

By Sam Forgione

NEW YORK (Reuters) - Top bond investors favor long-dated U.S. Treasury bonds over short-dated notes, using short positions in Eurodollar futures and short-dated Treasuries in anticipation that anxiety over the Fed's path will dominate market action in the coming year.

It is expected the Federal Reserve will raise rates at the conclusion of its two-day meeting on Dec. 16. Investors say this is largely priced into the markets, but the pace of subsequent hikes is unclear. Many investors believe the Fed will raise rates at least twice in 2016, but it could boost the short-term rate three or more times.

Successive rate hikes in 2016 "will benefit the long end (versus) the short end," said Rick Rieder, chief investment officer of fundamental fixed income for BlackRock (NYSE: BLK), the world's largest money manager with $4.5 trillion in assets. "The long end is the better part of the curve," he said.

He also said he expected the Fed to indicate after the first rate hike that it would proceed with later increases at a gradual pace, and that it would be slow to reduce its balance sheet. He said that scenario would benefit 30-year Treasuries prices since it would prevent a flood of long-dated Treasury supply entering the market and weighing on prices.

Yields on Treasuries maturing between 1-3 years hit the highest levels in at least four and a half years this month as conviction has risen that the Fed will raise rates this week. On Monday, rates futures implied traders see a 79 percent chance that the Fed will move this week.

Short- and long-dated Treasuries this year have posted nearly identical returns. The Barclays 1-3 year Treasuries index <.BCUSA13> has posted a 0.71 percent return so far in 2015; the 20-year-plus index <.BCUSATSY20P> is up 0.68 percent.

While Rieder said he believed in a curve-flattener trade in 2016, he said he was not executing it currently and instead was moderately bullish on short-dated Treasuries across BlackRock's bond portfolios since the impending Fed move had largely been priced into that part of the curve.

He said that while BlackRock was using Eurodollar futures contracts to bet against short-dated Treasuries across the firm's bond portfolios, BlackRock had a moderate bullish position in short-term Treasuries overall in these portfolios, given their cash positions.

Other investors also use Eurodollars as a way of betting against the short end of the yield curve. Eurodollar futures are CME Group's most actively traded interest-rate futures contract and represent a key short-term interbank borrowing level.

Julien Scholnick, portfolio manager at Western Asset Management Co., which managed more than $446 billion in assets as of Sept. 30, expects three interest rate increases next year.

The anxiety over the exact timing of subsequent rate hikes would likely put more selling pressure on short-dated Treasuries next year. As a result, he said Western added to short positions against short-term Eurodollar futures contracts earlier this quarter.

Speculative net short positions in Eurodollar futures stood at 251,157 contracts last week, according to Commodity Futures Trading Commission data released on Friday.

"The increase in volatility that we've seen over the course of the year is not going to end just when the Fed goes for the first time," he said.

Scholnick said Western added to an overweight position in long-dated Treasuries earlier this quarter, expecting inflation to remain low. Higher short-term rates could hurt spending, which would also dampen inflation, he said. Low inflation reduces the risk of long-dated bonds' interest payouts being eroded over time, and that diminished risk tends to attract buyers and boost the bonds' prices.

Michael Temple, portfolio manager at Pioneer Investments, said anxiety over the timing of subsequent rate hikes would remain after the Fed's first move and that he had positioned for a flattening of the yield curve into 2016 within Pioneer's multi-sector bond funds.

He said those funds were shorting 2-5 year Treasury futures and maintaining a neutral to bullish position in long-dated Treasuries.

"I don’t think that we are going to have that warm and fuzzy feeling" after the Fed hikes rates for the first time, Temple said. Pioneer managed over $244 billion in assets globally as of December 2014.

(This story has been refiled to correct "the anxiety" rather than "his anxiety" in paragraph 11.)

(Reporting by Sam Forgione; Additional reporting by Dion Rabouin; Editing by Dan Grebler)



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