Federal Reserve officials expect to raise interest rates three times in 2018. Higher rates are a response to faster economic growth, which the Fed expects in the coming year.
But, at least for now, traders don’t agree with the Fed. In the futures markets, traders are betting with real money that interest rates are going to decline. Traders can use futures markets to profit from changes in interest rates. If they believe rates will fall, they can buy futures contracts on bonds.
One group of large traders is called the “smart money.” This group is right about major trends more often than not.
Betting on a Decline in Interest Rates
Futures contracts are leveraged investments. Leverage involves borrowing money to increase potential returns.
That means a trader can buy $100,000 worth of bonds for less than $1,000. That also means futures are risky, and traders tend to cut losses quickly since a 2% move in the market results in a loss of $2,000, more than twice the amount of money invested in the contract.
Like stock markets, government agencies set the rules of the game. To keep markets fair for all investors, large traders are required to report what they buy and sell.
The weekly reports of traders’ positions let us see what the smart money is doing, and right now, the smart money is betting against the Fed.
That’s a chart of two-year Treasury notes. The data at the bottom of the chart is the Commitment of Traders (COT) report. It’s published by the Commodity Futures Trading Commission every week.
The COT report details the position of large speculators, which includes hedge funds, small speculators and commercials. The commercials are the large investors that know the market the best. They trade futures contracts as part of their business operations.
The chart shows the number of contracts different groups of traders own. Commercials, including traders working at large investment banks and mortgage companies, are buying the notes. Hedge funds, the red line, are selling.
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