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Hedge funds cash in on the ‘great reflation trade’

Hedge funds’ bet that US President Joe Biden’s $1.9tn stimulus package will help drive a resurgence in inflation is starting to pay off, with several big-name managers raking in large gains at the start of 2021.

Managers including Caxton Associates, Odey Asset Management and QMA Wadhwani are chalking up juicy returns as expectations of faster price rises send government bond prices tumbling.

“Hedge funds have been warning for six months that inflation could come in much hotter than expected,” said Andrew Beer, managing member at fund firm Dynamic Beta Investments, whose DBMF strategy rose 4.4 per cent last month, helped by bets against 30-year US Treasuries. “February showed how few investors are prepared for a rapid rise in interest rates.”

Bond prices, which have been in a 40-year bull market, have slumped in recent weeks in anticipation that huge levels of monetary and fiscal stimulus will drive a US economic rebound that will force the Federal Reserve to raise interest rates sooner than previously expected. Supporting this have been robust US retail sales and manufacturing data, as well as surging commodity prices and progress on vaccinations in the US and UK.

Long-term Treasuries, those with maturities of 10 years or longer, have recorded a loss of 10 per cent since the start of 2021 on a total return basis that takes into account price declines and interest payments, according to a Bloomberg Barclays index.

Meanwhile, the five-year break-even rate, a market-based measure of inflation expectations, exceeded 2.5 per cent on Wednesday for the first time since 2008, Bloomberg data show.

“The stage may well be set for a great reflation,” Caxton chief executive Andrew Law wrote in a December investor letter seen by the Financial Times. He added that it would be “a likely dominant investment theme”.

Line chart of Five-year break-even rate (%) showing US medium-term inflation expectations hit 13-year high

That bet has paid off: Caxton, which last year posted its best ever returns, has gained 7.2 per cent in its Macro fund, run by Law, and 4.5 per cent in its main fund this year, according to an investor.

Meanwhile, Odey’s European fund, managed by founder Crispin Odey, gained 38.4 per cent last month, according to investor documentation seen by the FT, taking gains this year to 51.1 per cent. The fund has been running large bets against UK and Japanese government bonds. The firm recently wrote to clients to say it expected US inflation at 10-to-15 per cent this year. This far exceeds the estimates of economists in a Bloomberg poll, who on average expect consumer prices to increase 2.3 per cent this year.

Brevan Howard, the firm co-founded by billionaire Alan Howard and headed by Aron Landy, gained around 3.4 per cent this year to mid-February. The firm has been positioned for an uptick in yields, said a person familiar with its positioning. Brevan, Caxton and Odey declined to comment.

Hedge funds such as Caxton and Brevan Howard made large gains last year from betting on bond yields slumping, as central banks slashed interest rates and investors fled to havens.

Such funds have now flipped their bets, say people familiar with their positioning, with concerns growing among top money managers that bonds have reached unsustainable levels.

Low bond yields are “an accident waiting to happen”, wrote Paul Singer’s Elliott Management in a recent investor letter seen by the FT. Warren Buffett warned last week that “bonds are not the place to be these days”.

Line chart of 10-year yield (%) showing US Treasuries are in a long-term bull market

Some funds have held the trade through so-called ‘yield curve steepener’ positions — bets that the gap between the US two-year and 10-year yields will widen. Higher yields point to lower prices. Steepener trades have proved profitable this year, as that gap hit its highest level in more than four years last month.

Other managers have profited from bets on stocks likely to do well as inflation rises. Odey’s James Hanbury gained more than 20 per cent in his Brook Absolute Return funds last month, according to numbers sent to investors. He wrote in January that he had positioned for higher inflation because of progress on the vaccine and supply shortages in many industries, according to an investor letter.

Computer-driven funds have also been profiting from both the sell-off in bonds and from commodity prices, which have soared as investors have sought inflation hedges.

QMA’s Sushil Wadhwani, a former member of the Bank of England’s Monetary Policy Committee, told the FT he expected global inflation to rise “materially” this year, driven by higher commodity prices, fiscal stimulus and pent-up demand in the economy.

“The rise in bond yields in February represented them ‘catching up’ with” moves in equities and commodities, he said. His fund gained around 8.5 per cent last month, helped by bets against bonds, ‘steepener’ trades and positions in commodities.

Also profiting is London-based GSA Capital Partners, whose Trend fund gained 5.3 per cent last month, taking gains this year to about 4.2 per cent, helped by bets on rising commodities and falling bonds, said a person who had seen the numbers.

With bonds rebounding in recent days some managers, such as Wadhwani, warn prices may have moved “too far, too fast”. However, others believe the Fed’s tolerance of higher inflation means bond prices can fall further. Kamran Moghadam, who heads the global macro team at Partners Capital, said he was reducing bond holdings because of “rising inflation risks”.

“It’s moved a long way very quickly,” said the head of one major hedge fund. “But the trade is still in play.”

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