Why are commercial bonds so short?

Eric Fry - Fri 20 Oct, 2006

...whenever the Commercials hold extremely large long or short positions on a specific commodity future, investors ignore this fact to their peril...

 
 
- "Oh wow...That's incredible!"

- Squiggles on a graph rarely elicit "Oh wow!" from your even-tempered California editor. Typically, he reserves his "Oh wows!" for animate, three-dimensional phenomena.

- But in this particular case – looking at the net long/short position of Commercial bond traders in US Treasurys right now - he simply could not stifle his amazement.

- "Why are the Commercial bond traders SO short the US government bond market?" he wondered to himself. "Why are they are holding their largest net short position – by far – of the last twenty years?"

- The short answer is that we simply don't know. We do not know why the "Commercials" are so short; we only know that this situation is VERY unusual and, at the margin, NOT bullish for 10-year US Treasury notes.

- The Commercial futures traders, as we have noted several times in this column, tend to position themselves correctly in advance of major turning points. In other words, they tend to "buy big" just before major rallies and "sell big" just before major corrections.

- These "smart money" guys aren't ALWAYS so smart, of course. They often find themselves on the wrong side of a trade for a long time. But whenever the Commercials hold extremely large long or short positions on a specific commodity future, investors ignore this fact to their peril.

- During the summer months, for example, the Commercials had amassed very large net-long positions in wheat and very large net-short positions in crude oil. Shortly thereafter, wheat soared and crude oil tanked. As noted, the Commercials aren't always so smart. But neither are they often very stupid...which brings us back to their record-large short position in T-note futures.

- The fact that the Commercials are holding an extremely large net-short position in 10-year US Treasury note futures does not mean that the US Treasury market is about to tank. But neither does it mean that it is NOT about to tank. For the last few months, the US Treasury market – and with it the market in bonds pretty much around the world - has been enjoying the favourable tailwinds of falling inflation expectations and evaporating rate-hike expectations.

- The US Treasury market has also enjoyed record-high foreign buying. And every bond market analyst on CNBC now seems to know that interest rates are heading lower, too. Likewise, every investor in America now seems to know that interest rates are heading lower...every investor except for the Commercial traders of T-note futures.

- Perhaps, and we are only guessing now, the Commercial T-note traders believe that the 10-year Treasury note is already priced for perfection. Perhaps they believe that the 10-year's lean 4.77% yield already reflects a world of falling inflation, falling interest rates and eager bond buyers. If any or all of these favourable trends were to slacken or reverse bond prices could fall rather quickly. But again, we are only guessing.

- This week's sharp 1.3% drop in US producer prices certainly supports the inflation-is-falling theory. Thanks to a stunning 22% drop in gasoline prices during the month of August, US producer prices fell by the most in three years. The drop in producer prices is certainly welcome, but it probably is not repeatable. Gasoline price did not fall another 22% in September and they are unlikely to fall 22% in October. In fact, they are already rebounding, as are the prices of all other energy products.

- Meanwhile, the Federal Reserve's various mouthpieces have been dampening hopes of near-term rate cuts. "The bottom line is this: With inflation too high, [monetary] policy must have a bias toward further firming," declared San Francisco Fed President Janet Yellen early last month. Several other FOMC members have echoed Yellen's lip-service to a tight monetary policy. Read: higher interest rates ahead.

- The perfect environment for US bond-buying is also likely to become less enthusiastic. During the month of August, international investment in US securities swelled to a record $116.8 billion – more than triple the July tally. Purchases of US Treasury securities, alone, totalled a whopping $46.3 billion – more than seven times the July tally. These hefty Treasury purchases certainly helped to fuel the US bond market's mid-summer rally. But we would be surprised to see foreign investors toss $46.3 billion into the US Treasury market EVERY month.

- We do not know why the Commercials are holding such a large net-short position in T-note futures. We do not know why they are betting so heavily that T-note price will fall. Perhaps they realise that perfection often gives way to imperfection, and that imperfection often produces lower prices...

- But we're only guessing.


Regards,

Eric Fry
for The Daily Reckoning