Is a Squeeze in Bonds Coming?

As sentiment shifts from a Fed rate-cutting forecast to one that now sees a chance of a rate increase, a potentially powerful short squeeze setup might be emerging in the Treasury market. Heading into the Iran conflict, speculative short positions in TLT and Treasury futures were near historically elevated levels, reflecting a broad consensus that yields would increase.

Then the conflict broke out, and oil prices surged. Rather than following the traditional flight-to-safety script of falling yields and rising bond prices, yields increased as inflation fears took hold in the bond market.

Higher yields, including nearly 5% on 30-year bonds, could set up a bond short squeeze. When or if higher oil prices lead to economic weakness, or if the Iran conflict de-escalates faster than expected, the Fed could quickly shift back toward a dovish stance more aggressively than the market anticipates.

Further, the unwinding of the oil premium, combined with weaker economic growth and buying by yield seekers, could force a rapid unwinding of elevated short positions and drive a short-squeeze rally in Treasury prices. Investors who have been shorting bonds for the past month have been rewarded, but the bigger the short base, the more likely a meaningful reversal.

As we wrote in last week’s Commentary, the Donald Kohn framework suggests that rate cuts are more appropriate than rate hikes in the context of a supply-driven oil shock. If the Fed and the market come around to that perspective, a bond market short squeeze may catch many investors by surprise.

The Week Ahead

In the prelude week to corporate earnings, there will be a decent amount of data to digest. The likely headliners will be CPI on Friday and PCE on Thursday. Bear in mind, PCE covers the February time frame, so it will not include the impact of higher oil prices. CPI is expected to rise by 0.8% in March; however, Core CPI is expected to rise by only 0.2%.

Thus, higher energy prices will exert themselves in this report. As we have discussed, the Fed primarily focuses on Core inflation; thus, the potentially high headline CPI should not be a surprise to the stock or bond markets. Further, higher yields and lower stock prices already reflect the increase in oil prices.

The FOMC minutes on Wednesday may shed some light on how the Fed balances the inflationary impact of the Iranian conflict with the negative effect on the economy. The market will focus on how they speak to both risks and the balance of those conversations. Currently, as shown below, the market is pricing in a mere 3bps of rate cuts through November.

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