Hedge funds raise bets against European government bonds to two-year high

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Hedge funds have amassed their biggest bets against Eurozone government bonds in more than two years, in expectation that the European Central Bank will have limited room to cut interest rates further this year.

The total value of bets against European government bonds hit $413bn this week, according to data from S&P Global Markets Intelligence, as measured by bonds out on loan. That was up 8 per cent since January and the highest level since April 2022.

The rise in bets came ahead of the ECB delivering a well signalled 0.25 percentage point interest rate cut from a historic high of 4 per cent on Thursday.

But it also raised its inflation and growth forecasts for the rest of the year and removed an explicit easing bias from its monetary policy statement.

“The big picture here is that inflation numbers had been coming down but had a nasty uptick,” said Robert Tipp, head of global bonds at PGIM Fixed Income. “In my opinion they made the mistake of signalling and boxing themselves into a cut even though the data was suggesting they should have held up.”

Eurozone inflation rose for the first time this year in May to 2.6 per cent, with services inflation rising to a seven-month high. Raising its predictions for this year and next, the ECB said on Thursday that inflation would average 2.5 per cent in 2024 and 2.2 per cent in 2025. However, its forecast for 2026 was unchanged at 1.9 per cent. Its target is 2 per cent.

On Thursday Christine Lagarde, president of the ECB, said policymakers had decided to cut because of their “confidence in the path ahead” but added that she “wouldn’t volunteer” the notion that the central bank has moved into a dialling back phase.

Markets have increasingly moved to price in a shallow easing cycle for the ECB, with a 76 per cent chance of the next cut by September. A month ago, another cut by then was fully priced in.

Line chart of Market value on loan ($bn) showing Short positions on European government bonds have risen this year

Short positions on German government bonds — the benchmark for the Eurozone — have risen by 10 per cent since January to $112bn. Yields on 10-year Bunds have risen from 2.1 per cent to 2.5 per cent, representing a fall in prices. 

The biggest rise in short positioning, according to S&P’s data, has come in Italian bonds, where the value borrowed by investors has risen 38 per cent since the start of the year. That suggests some investors are losing confidence in a rally in Italian debt that has narrowed the gap between Italy and Germany’s benchmark borrowing costs from 1.65 percentage points to 1.31 percentage points since the start of the year. 

Other measures of investor positioning paint a more optimistic view on the outlook for European bonds. Bank of America’s monthly fund manager survey showed asset managers were slightly overweight European bonds relative to their benchmark.

However, Alex Batten, a fixed income fund manager at Columbia Threadneedle Investments, said he preferred to own US government debt over European debt.

“Europe will not be immune to the US experience of inflation taking time to recalibrate back to target,” he said.

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