Hedge Funds Go Against Grain, Bet On Steepening Yield Curve

The Federal Reserve’s recent pivot towards a more aggressive strategy to fight elevated inflation has flattened the yield curve, which indicates that some investors anticipate the US central bank’s policy tightening could eventually hinder longer-term economic growth. However, some hedge funds are betting that pricing in the bond market that reflects pessimism about the US economy will not last, even though this cost some of the biggest players billions of dollars in 2021. Traders and strategists say that some hedge funds are betting that the yield curve, which shows the different interest rates that investors demand for holding shorter and longer-dated government debt, will not flatten much more.

This optimism flies in the face of the worries of some economists that the yield curve shows signs of actually inverting, where short-term debt instruments have higher yields than long-term instruments of the same credit risk profile. Historically, an inversion of the yield curve has been a leading indicator of recessions, although this predictive ability is not without controversy despite its ability to anticipate downturns enduring across specifications and time periods. Some hedge funds are once again betting that yields on long-term US government bonds will eventually rise, and rise more than yields on shorter-term debt.

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Hedge funds have been betting on a steeper curve on and off for months, expecting that as economies emerge from coronavirus lockdowns, inflation will accelerate and longer-term bonds will sell off, pushing yields higher. However, while this strategy worked in the first few months of 2021, the bet proved painful during the spring and early summer, and again in the autumn, as the market moved to price in the likelihood that central banks would act to curb inflation. According to the data group HFR, falling Treasury yields — driven by central bank-induced volatility and Omicron-fuelled market swings — contributed in November to hedge funds’ worst performance since the beginning of the pandemic. Still, the persistence of hedge funds to bet against pessimism in the US economy is a solid indicator that the Omnicron variant will not have the same negative effects as the initial wave of coronavirus, nor that the efforts of central banks to curb inflation will further flatten the yield curve.