Who Wears Short Shorts?

Summer is here, maybe not on the calendar but in spirit and weather. It occurred to me that much of my recent financial thinking has matched my attire – a lot of attention spent thinking about shorts. 

Shorts have a very different connotation and definition within the context of markets than in fashion of course. Yet as I look back at the themes that have driven the bulk of our recent market commentary, shorts have played a theme throughout.  On Monday, I asserted that the some apparently bullish demand in AMC was actually the result of hedging by bearish traders.  On Tuesday, I explained the concept of naked shorting and why I felt that it was not a key factor in the current marketplace. I have always treated shorting as simply another, riskier way to make money, a view shared by many other professional traders.

Yesterday’s market activity was clearly driven by short-covering, though in the bond rather than the stock market. Many were understandably perplexed when bonds rallied in the face of higher-than-expected CPI numbers. The longer end of the Treasury yield curve is highly sensitive to inflationary expectations, which would of course be bolstered by higher CPI readings. While some of the commentators focused on the more transitory elements of the key inflation statistics (used car prices, for example), I watched the trading closely and thought that it bore all the elements of nervous short covering.

Let’s analyze a 3-day chart of September 10-Year note futures:

10-Year Note Futures (September, ZNU1), 3 Day Chart, 1-minute Bars

(Click on image to enlarge)

10-Year Note Futures (September, ZNU1), 3 Day Chart, 1-minute bars

Source: Interactive Brokers

Pay particular attention to the fleeting spike lower at the start of yesterday’s trading. That was the type of move that one would expect – a downdraft after an economic release that was worse than consensus. The subsequent rally caught many by surprise, and stock traders – seeing the favorable reaction in bond prices – jumped on the bandwagon. I look at the spike as a classic short panic. Here’s why.

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