Last week witnessed the “capitulation trade” from the myriad of short sellers in the global interest rate markets. The shorts were predominantly hedge funds and professional investors who have been betting that interest rates will rise in the US for the best part of five years. “Capitulation” occurs when these investors can no longer bear the pain of negative carry coupled with capital losses as interest rates continued to fall across the curve. October 15, in particular, saw the US 10 year yield fall from 2.10% to 1.84% in the space of half an hour as the shorts scrambled to cover.
While Wall Street licked its wounds publicly in the media, very little has been said about the identity of the winners from this capitulation. The fact is that for every borrower in the bond market there is a lender such that the net supply of bonds is zero. Thus for every loser there is a winner. Just who are these winners?
The natural owners of government bonds are, in fact, the central banks and sovereign wealth funds from the creditor countries across Asia, the Middle East and a smattering of other countries with advantageous cost structures and endowments. These institutions have been not only quietly profiting from the losses being racked up by short-term speculators, but continuing to add to their long positions in the government bond markets.
Potential short sellers take note: These investors are long-term holders of debt which means they are not price sensitive, nor are they likely to sell their positions to “take profits”. In the absence of these investors liquidating their holdings, this suggests that the low levels of interest rates on offer currently are here to stay for a very long time.