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.

We’ve all heard the phrase “buy the rumor, sell the news”.It refers to the widely acknowledged phenomenon that if traders are already widely anticipating an event that is likely to be positive for a stock, it may be fully priced in by the time the good news arrives and there aren’t enough fresh buyers to push it higher. Guess what, the same thing applies in reverse to short traders and bad news.In this case, bond traders were already anticipating an unfriendly CPI reading. Upon finding a lack of follow-through selling, any traders who were short were then forced to push prices higher. That fed upon itself, and we had the counterintuitive sight of bonds rallying on bad news.

There is a broader reason for my conviction that short covering was the primary culprit. It requires us to look at a longer-term chart of T-Note futures:

10-Year Note Futures (September, ZNU1), 6 Month Chart, 1-Day Bars

(Click on image to enlarge)

10-Year Note Futures (September, ZNU1), 6 Month Chart, 1-Day Bars

Source: Interactive Brokers

We can see the huge decline in prices (rising yields) throughout the first quarter of last year.I believed at the time – and still do – that the market had begun pricing in higher inflation, but that the last leg down was more about portfolio managers window dressing ahead of the end of the first quarter. Portfolio managers often want to avoid holding too much of a poorly performing asset before major reporting periods, and I believe that drove much of the rush for the exits that we saw in March. I believe it is absolutely no coincidence that the low was reached on March 31st before bouncing.

I now believe that the opposite effect is in place. Bond prices have performed reasonably well this quarter, so there is incentive for managers to show long positions before the second quarter ends in less than 3 weeks. Combine that with the idea that higher inflation and the huge demand for reverse repos could force the Fed to maybe start thinking about talking about possibly tapering their bond purchases, and we can see how traders and investors alike could now find themselves either underinvested or outright caught short ahead of yet another key reporting period.

Stock traders tend to think of their bond counterparts as having a clearer view of economic fundamentals and are usually willing to follow their lead in the wake of economic events. That was certainly the case yesterday. But we often fail to remember that traders, no matter what the product, are still driven by the interplay between fear and greed.  Yesterday it appeared that interplay incentivized bond traders to buy even in the face of bad news. Stock traders, who haven’t been particularly focused on fear lately, were glad to take that lead.



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