Tuesday, July 9, 2019

Follow the relative spread trades from futures traders - They have knowledge

Bond traders may be good macro forecasters, at least if you look at the position-taking of speculative futures traders. The commitment of traders (COT) report (commercial and non-commercial futures positions) from the CFTC for bond and interest rate futures can tell us something about speculative forecasts. Using the net number of speculators in bond futures across the curve, investors can extract forecasts about the change in the slope of the yield curve and thus information on the macro economy. 

The commitment of traders across the yield can be thought of as the revealed preference of speculators about the future shape of the curve. The relative positioning of speculative traders between short and long-term bonds provide a good indicator of the yield curve direction. These curve bets can also tell us something about payroll surprises that are not fully account for professional macro forecasters. These steepening curve forecasts for speculators also provide information on the direction of stock prices. 

This interesting work was conducted by Yang-Ho Park of the Federal Reserve Board staff in his paper "Information in Yield Spread Trades". Park takes the net excess speculators (non-commercial traders) in the 3-month eurodollar futures versus the 30-year (bond) futures to form a steeping indicator if positive and a flattening indicator if negative. This speculative trader indicator is like using the yield curve to forecast future economic activity but with a focus on a group that makes its livelihood trading markets. This research shows is that there is incremental value with using the speculative positioning for recession predictions beyond the term spread. The same result is found for non-farm payroll numbers. The research also finds that spread trading indicators provide added information over an outright trade indicator for a number of futures markets. 

There may be more room for further research in this area since the CTFC also has a long-form report for the commitment of traders which provides more detailed information on dealer, asset manager, and leveraged fund investors. Additionally, the size of the position may provide more information beyond the number of speculative traders. Some may view these as sentiment indicators that add to the arsenal of information beyond price and fundamentals. Certainly the COT data provides details on the behavior of key trading groups in the markets.

What does the data tell us now? The trader numbers from the latest CTFC report are suggesting that the net speculative trader profile is focused on a flattening curve which is slightly perplexing given the active view that the Fed will engage in multiple cuts in rates. It is notable that speculative trader positions are net long the eurodollar futures in the front-end of the curve but the 30-year bond futures speculative positions are almost flat, so the position data is contradictory with the net trader data. The dealer and levered fund communities are net short although the net trader number is almost flat. From the view of traders, perhaps the market has gotten ahead of itself. Trader commitment signals are slightly mixed. 

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