Hedge funds have been borrowing record sums of money to place bets in both the equity and bond markets. In the latter asset class, they appear to be taking a view on the direction of interest rates that’s the direct opposite of that held by asset managers. However, the employment of relative strategies is the likely explanation for this divergence.
Back in March, Reuters reported that hedge funds were using more leverage to make wagers on the stock market, but were less inclined to bet on the market’s direction due to heightened macroeconomic uncertainties. Reuters cited the example of long-short hedge fund Anson Funds, with $1.5 billion in assets under management, which had adopted a roughly neutral stance, with shorts and longs matching off. 1
Since then, stock markets have confounded expectations by rising even further despite continuing uncertainty about the macro-economic outlook – and, in particular, whether the US economy can achieve a ‘soft landing’ and how high interest rates across the Atlantic will go.
Now, having missed the global equity rally, hedge funds are resorting to higher leverage again, this time ‘to amplify returns, with the pressure being on them to deliver substantial returns to justify their high fees in an environment of elevated interest rates’, according to the stock research platform Quiver Quantitative. 2
Quiver added that this year, long-short equity hedge funds have lagged behind the benchmarks, primarily due to losses from short sales.
In June and July, hedge funds closed short positions and reduced risk at the most rapid rate in years as US stocks moved higher still and forced many short-sellers to purchase stocks at elevated prices, further propelling the rally.
Short covering has reduced hedge-fund leverage from its peak this year, yet leverage levels remained notably high in late July.
Hedge funds are also taking large leveraged positions in the US Treasury bond market, a strategy that could ‘amplify stress’ in global financial markets should rates move sharply, the Bank of England warned in July. 3
Hedge funds added further to their short positions in Treasuries in July, according to Bloomberg, which reported that bearish Treasuries bets had risen to record highs. The news agency cited aggregate Commodity Futures Trading Commission data for the week ending 1 August, which showed that leveraged funds had increased their net short positions of longer-maturity Treasuries derivatives to the highest level since 2010.
Yet asset managers are betting that yields will fall and prices rise as slowing US growth prompts eventual rate cuts. Hence, asset managers have been adding to already record longs in US Treasuries.4
The figures would appear to suggest that asset managers and hedge funds have opposite views on the outlook for interest rates in the US, at least. However, Cavenagh Research, an analyst at Seeking Alpha, argues that this is unlikely. Rather, they believe that the hedge-fund strategy of undertaking relative-value trades – where funds identify discrepancies in prices and exploit opportunities for profit – provides the explanation. In this case, Cavenagh Research believes that hedge funds may be shorting treasuries to buy more stocks.5 If the market moves against either or both strategies, hedge funds could be left in a difficult position.
1 https://www.reuters.com
2 https://www.quiverquant.com
3 https://www.bloomberg.com/news/articles/2023-07-12/hedge-funds-us-treasury-bets-pose-stability-risk-says-boe
4 https://www.bloomberg.com/news/articles/2023-08-07/hedge-funds-boosted-record-treasury-shorts-as-markets-convulsed
5 https://seekingalpha.com/article/4622348-hedge-funds-are-shorting-treasuries-en-masse
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