ACTV - Interest Rates May Surge As The Short Squeeze Nears Its End

2023-03-20 12:45:29 ET

Summary

• It appears there's a short squeeze taking place in Treasury rates.
• Liquidity in the Treasury futures has evaporated, making the short squeeze even more painful.
• Once liquidity returns and short covering subsides, rates should rise sharply.

The recent drop in Treasury rates may have gone too far and seems to have held critical technical levels thus far. This suggests that interest rates could rise from current levels.

The primary reason for the sudden move was the news of Silicon Valley Bank's (SIVB) failure, which triggered a flight to safety and induced a massive wave of short covering across the entire yield curve. This has caused rates to drop sharply, giving the impression that the market is pricing in Fed rate cuts.

Short Covering

Short positions among leveraged funds across the yield curve have become very large, and these funds have suffered significant losses in recent days, as indicated by the SG Trend Index. The index, which tracks the commodity trade advisor's net daily rate of return, has fallen by 10.3% from March 8 to March 16, wiping out all of the index's gains over the past year.

The SG Trend index has followed the changes in rates over the past two years. This suggests that the recent sharp decline in yields has been the primary driver of the sudden and significant decline in the SG Trend index.

Over the past several months, the big trade was shorting the yield curve among levered funds because the outlook was for the Fed to raise rates pushing nominal rates higher. This led to a significant build-up in the short positions for the 2-year, 5-year, and 10-year Treasury futures contracts.

However, with the recent market scare and flight to safety, the models have likely shifted from a short signal to a cover signal, as evidenced by the 20-day moving average flipping from rising to falling.

Liquidity Has Evaporated

The primary problem is that liquidity in these futures contracts has dried up, and the bid-ask spread has widened, making it difficult to unwind bearish bets on the yield curve and exacerbating the move in rates.

When the depth of the book thins out, it means that there are not as many futures contracts available to buy or sell without significantly affecting the underlying contract. When the spread widens, it makes trading even more expensive. The wider the spreads become and the thinner the top of the book gets, the more challenging it is to execute transactions. The 2-year futures contract, for example, has experienced a significant decline in book depth and a significant widening of the bid-ask spread.

A similar situation is visible in the 5-year Treasury futures contract, with the bid-ask spread widening significantly and the book depth thinning out. This trend is also noticeable in the 10-year futures contracts.

Consider that leveraged funds are struggling to unwind short positions. At the same time, liquidity in the market evaporates has probably caused rates to drop sharply and the violent moves that have been recently witnessed.

Interestingly, this is visible on the technical charts, as the 200-day moving average has provided crucial support for the 2-year, 5-year, and 10-year Treasury rates. This level of technical support is significant because it can indicate the long-term direction of the overall movement in rates. As long as this moving average holds, it seems to suggest that rates could see a significant rebound in the coming weeks.

Rate Cuts?

At least on the surface, similar conditions seem to exist in the 3-month SOFR futures contracts, with substantial short positions built up over the past few months. If the race here is to cover short positions, it could be creating the impression that the markets are pricing in rate cuts when, in reality, it's just systematic short covering due to model signals.

As short covering eases and liquidity improves in the market, rates in the US will likely recover and rise significantly, especially if the Fed raises rates this week and signals for more rate hikes to come.

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