It’s understandable why some folks might still be leery about investing in bonds. After all, a loss of more than 30% in long-dated Treasuries during a year when the S&P 500 also lost nearly 20% isn’t exactly confidence inspiring.
That doesn’t mean, however, that opportunities don’t exist. If we assume that the primary catalyst for the bond bear — the Federal Reserve’s aggressive rate hiking cycle — is nearing its completion, there’s a very real case to be made that Treasuries look attractive once traditional risk-off behavior resumes.
Beyond that, conditions still support the idea of a likely recession coming in the next several quarters. If you’ve followed my work, you know that I closely watch lumber prices as a signal for where the markets could be headed next. The reasoning is pretty straightforward. Lumber is a “tell” on housing and housing is a “tell” on the economy in general. A decline in the housing market almost always takes the broader economy with it. Lumber prices currently are indicating that risks are quite elevated.
You can see that lumber prices were on the decline in advance of nearly every recession over the past half century, the recession in 1990-1991 being the notable exception. What do we have today? Lumber prices are down more than 30% from their January 2023 peak and more than 70% from their post-Covid-19 high. If lumber price declines lead recessions and recessions usually lead to rallies in government securities, you’ve got more evidence for another bull market in Treasuries ahead.
So, we’ve got two potential catalysts already for Treasuries — the end of the Fed’s rate hiking cycle and a likely recession ahead. A third potential catalyst could make the best case of all for a Treasury bull – the “epic” short squeeze!
Is a Short Squeeze Underway in Treasuries?
Earlier this month, we learned that hedge funds currently have a record net short position in 10-year Treasury bond futures contracts.
Not that we want to hold hedge funds up as the bastion of excellent market timing, but there has been some correlation to their positioning and the direction of Treasury yields. In fact, it’s worked pretty well as a contrarian indicator!
Hedge funds spent much of the late 2010s being net sellers of Treasury futures right at the time when long-term yields were falling and Treasuries were rallying. When they started shrinking their positions and eventually becoming net buyers, Treasury yields shot higher again. Now, hedge funds have a huge net short position at the exact time it looks like yields may have already peaked. Does this mean that long-dated Treasuries are set up for a huge short squeeze driven by hedge fund traders? If recent history is a guide, the answer could be yes.
In my opinion, Treasuries are setting up very nicely here. Over the past 2-3 weeks, we’ve seen equities begin pulling back somewhat, especially in high-beta stocks, at the same time that Treasuries have been gaining. That could be marking the early stages of the return of traditional risk-on/risk-off dynamics. If that carries forward, conditions could be favoring a big rally for Treasuries.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
