If the US CPI in March shows weakness, the market reaction may be more dramatic.
The U.S. March CPI, which is seen as an important piece of the puzzle for the Fed's rate cut expectations this year, will be released tonight. Before the release of this key data, U.S. Treasury traders have become extremely bearish, and their short positions in U.S. Treasuries may face a squeeze if the actual data is not as hot as they expected.
Weekly data from the U.S. Commodity Futures Trading Commission (CFTC) show that funds that use borrowed money to leverage increased their short positions in U.S. Treasury futures for the first time in two months amid the recent rise in Treasury yields. Investors also increased their short positions in the spot market. JPMorgan Chase's latest client survey showed that as of April 8, clients' short positions increased, with a net neutral position instead of a net long position for the first time in nearly a year. But outright short positions are still the largest since the beginning of the year, while outright long positions are the smallest since February. CFTC data showed that leveraged funds expanded their net short positions for the first time since the end of January in the week ending April 2.
U.S. Treasury yields hit their highest point of the year this week after signs of a strengthening U.S. economy and cautious comments from Federal Reserve officials led traders to keep reducing expectations for rate cuts in 2024. Trading sessions on Friday and Monday both showed an increase in short positions in U.S. Treasuries, and changes in open interest reflected that traders were hedging against the risk of further increases in U.S. Treasury yields.
On Tuesday, U.S. Treasuries recovered some of their recent losses, with yields retreating slightly from their highs. Now, traders are waiting for the CPI report on Wednesday, which could confirm the Fed's more hawkish stance or lead to another repricing of rate cut expectations.
Economists predict that both the headline CPI and the core CPI will rise 0.3% month-on-month in March. Wells Fargo analysts wrote in a report on April 5 that because the U.S. bond market is so pessimistic, if the actual data released appears weak, it is likely to trigger a more violent market reaction.
“After the recent underperformance of bond markets, we believe that if core CPI falls short of the media’s forecast of 0.3%, the Treasury yield reaction will be more dramatic than if core CPI exceeds expectations,” they wrote.
There are already signs that some investors may be considering unwinding their positions ahead of the CPI data. A record block trade in short-term interest rate futures gave a big boost to short-term bonds on Tuesday, which appeared consistent with the actions of a direct buyer.
The trade involved Secured Overnight Financing Rate (SOFR) futures. Shortly after 9 a.m. New York time on Tuesday, 75,000 SOFR futures contracts expiring in December 2024 changed hands, with the Chicago Mercantile Exchange confirming it was the largest transaction of the product to date. Prices subsequently rose, indicating that the trade was initiated by the buyer, while U.S. Treasury yields slid further toward intraday lows.
If the March CPI data released tonight is good, renewing expectations that the Federal Reserve will cut interest rates three times this year, then the outright long position of the contract will be profitable. However, the transaction may also be to cover short positions to reduce risk before the data is released.
With yields at year-highs, the massive trade could be an early sign that some see short positions in Treasuries as overstretched. In addition, CFTC data shows that some asset managers have been willing to take on more interest rate risk recently.
Further boosting confidence in the inflation outlook, State Street Global Advisors, which manages $3.6 trillion in assets, predicted on Tuesday that the Federal Reserve will implement an aggressive 50 basis point rate cut in June. Meanwhile, Lael Brainard, chief economic adviser to President Biden, told CNBC that she expects steady progress on the road to reducing inflation in the coming months.
