Hedge funds are the most bullish on 10-year Treasuries since 2017

If hedge fund plays on the dollar and U.S. Treasuries are a weather vane for investors' risk appetite and the economic outlook more broadly, then hold on to your hats.

Chicago futures markets data show they have built up their largest long position in 10-year U.S. government notes in four years and increased their bet on a stronger dollar to its biggest in 18 months.

These trades — banking on low long-term borrowing costs, a flatter yield curve and a firmer dollar — indicate concern over future growth prospects, a strong desire for safety or lack of concern over inflation. Or all three.

Data from the Commodity Futures Trading Commission show that in the week to Sept. 28 hedge funds and speculators ramped up their net long 10-year Treasuries holdings by almost 120,000 contracts to 181,207 contracts, the most since October 2017.

This is the first glimpse into how hedge funds are repricing interest rate risk since the Federal Reserve's Sept. 22 policy meeting, which opened the door to an earlier and more aggressive tightening process than previously anticipated.

Funds' rush into 10-year Treasuries completely reversed their selloff ahead of the meeting, and coincided with a deterioration across financial markets as investors grappled with the prospect of interest rates rising next year.

Reflecting the Fed's hawkish tilt, speculative accounts more than doubled their net short two-year Treasuries futures position to 62,829 contracts.

So far at least, this bet is not paying off: The 10-year yield jumped to 1.55% last week from 1.30% the day of the Fed's policy statement, and the two-year/10-year yield curve steepened by 15 basis points to 125 bps.

But the warning bells are ringing. The S&P 500 had its first 5% drawdown in almost a year and September marked the biggest monthly fall since March last year; the VIX index jumped above 20; U.S. consumer sentiment hit a seven-month low, and the near-term growth outlook is dimming.

This is the kind of environment that favors bonds, a flatter yield curve and the dollar. On that final note, at least, funds are on a winner.

The dollar often performs well in times of slowing growth and rising economic uncertainty. On the face of it, this appears counter-intuitive, but in the relative world of exchange rates the dollar provides safety and liquidity.

Domestic U.S. and global growth momentum is slowing. Economists at Barclays note that softening business investment is consistent with the slowing in demand amid renewed COVID-19 infections, ongoing supply constraints and a cautious consumer.

Jamie McGeever is a columnist for Reuters.