Somebody Is Betting $75 Million On A Bond Rally - Is It You? Fess Up

Someone is wrong.
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If you were following along last Thursday, you know that sometime around 1:30 p.m. ET, the Brazilian real made a run at 4.00 USD, underscoring the extent to which emerging markets are being severely stress tested by expectations of Fed tightening.

According to Bloomberg, dollar offers "vanished" on the local futures market during that episode, which came during a session that witnessed "a total absence of USD sellers" on multiple occasions, to quote BBG again.

Effectively, TRY and ARS passed the baton to BRL in terms of where the market was focused when it came to looking for signs of EM angst. That's not to say the BRL story hadn't been playing out for months (it had), but last week marked a real (get it?) escalation in terms of the focus shifting from idiosyncratic stories in Turkey and Argentina to the broader EM complex as represented by Brazilian assets.

Perhaps more notable for most U.S. investors was what happened to Treasurys around the same time. Long story short: they "flash rallied" with yields plunging alongside the BRL.

10Y

Clearly someone got stopped out there (if you look at TY volume you can see there was quite a bit of action), but the larger issue is that that episode was just the latest example of the market's tendency to "snap" (as it were). It looks like that move might have started with risk-off sentiment tied to EM turmoil (as manifested in BRL) and then once Treasurys started rallying, someone got squeezed. Remember, short USTs is an extremely crowded trade, which means when things start moving against those positions, well, it's adios muchachos.

That came just a little over a week after Treasurys rallied the most since Brexit during the turmoil in Italian bonds. The selloff in the Italian front end was a 15-standard deviation event and the German bund rally that played out on the same day was a 7-standard deviation event.

The point: when increasingly interconnected markets collide with i) stretched positioning, ii) powerful macro narratives (e.g., EM crumbling, Italy imploding) and iii) the "wonders" of modern market structure, you end up with exaggerated moves like those described above.

"While the specific shocks may have been unpredictable, we don’t think they
were unforeseeable," Citi's Matt King wrote, in a note dated June 1, before adding that "the vulnerability of a complex system – like global markets – owes more to the interconnections between its elements than to any one element individually [and as such] investors should not be looking for the grain of sand which causes the avalanche, or at the match which causes the forest fire, but rather at the height of the sandpile or the dryness of the forest more broadly."

Ok, so believe it or not, all of that is a belabored attempt to set up a Bloomberg story out Tuesday that details a series of trades put on ahead of the Fed. To wit, from that story:

Over the first three days of this week, traders paid more than $75 million combined to buy almost 200,000 call options on 10-year futures. Coming just weeks after 10-year yields set an almost seven-year high above 3 percent, the bets amount to a bold call targeting a drop to as low as about 2.6 percent before the biggest chunk of the contracts expire Aug. 24.

You can read the details of those trades in the linked post, but the bottom line is that some folks appear to think that either the Fed is going take a dramatic turn for the dovish or else that exogenous shocks emanating from Italy or EM (with the latter perhaps cracking under pressure in the event the Fed leans demonstrably hawkish going forward) will catalyze a safe haven bid for the U.S. long end.

[Until the market starts to seriously question the sustainability of the U.S. fiscal position and/or until we get some kind of nightmare scenario where a U.S. recession comes along forcing the Fed to cut rates and undermine the dollar just as concerns about U.S. fiscal policy peak thus calling into question who would be willing to sponsor the U.S. long end, USTs are likely to benefit from safe haven flows.] 

So go ahead and speculate on what's behind these bullish bets - it's likely either a wager on a dovish Powell or a play on the assumption that turmoil in the rest of the world will ultimately catalyze a flight to safety (and again, depending on what kind of turmoil you're talking about, that could actually be a bet on a hawkish Fed).

But whatever the case, someone is wrong here because as Bloomberg also reminds you, "the positions are at odds with the stance of hedge funds and other large speculators, who hold close to a record short position in 10-year Treasury futures."

Right:

Specs

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