The yield on 10-year US Treasuries has risen in anticipation that the result will help president-elect Joe Biden push through generous doses of additional fiscal support ©  FT montage; Getty Images

Victory for Democratic candidates in this week’s Senate race in Georgia has boosted one of the hedge fund industry’s favourite trades.

Funds betting on higher long-term US borrowing costs are starting to profit as the balance of power in the US Congress shifts towards the Democratic party. The yield on 10-year US Treasuries has already risen from 0.955 per cent to 1.076 per cent in anticipation that the result will help president-elect Joe Biden push through generous doses of additional fiscal support to aid an economic recovery. Longer-term bonds have dropped even harder, steepening the so-called yield curve.

For several months, many funds had already been running this so-called reflation trade — bets against longer-term US Treasuries relative to shorter-term bonds — expecting the central banks and government stimulus of the past year in response to the coronavirus crisis to fuel inflation and economic growth.

Such bets hit a decade high last autumn and many funds have remained keen on the trade. The gap between five and 30-year Treasury yields now hovers at its widest point since 2016.

“[Yield curve] steepeners was a popular trade in 2020 and many funds are set to benefit from the Georgia Senate run-off result,” said Edoardo Rulli, head of research at UBS Asset Management Hedge Fund Solutions.

Line chart of Difference between five-year and 30-year Treasury bonds, basis points showing Yield curve steepens as investors anticipate inflation pick-up

The Georgia run-off vote on January 5 was not the driving force behind most funds’ bets, many of which have been running for months. But a “blue wave” Democratic sweep of Congress and the presidency amps up the chance of enhanced fiscal spending and bolsters the case for the reflation trade.

“I expect reflation as a likely dominant investment theme,” wrote Andrew Law, chief executive of $6.1bn-in-assets hedge fund firm Caxton Associates, in a letter to investors last month. Caxton made strong gains late last year from market moves that have continued into 2021, according to one investor.

Mr Law pointed to the US Federal Reserve’s increased tolerance for faster consumer price increases as yet another driver of higher inflation. “Conditions are in place for it [reflation] to run until further notice,” he added. 

Market measures of inflation expectations have already begun to reflect this reality. The 10-year break-even rate, which is derived from prices of US inflation-protected government securities, breached 2 per cent for the first time this week since late 2018. In September, it languished at about 1.6 per cent. 

Line chart of US 10-year break-even rate, % showing Rise in inflation expectations accelerates after Georgia elections

Hedge funds tend to report their performance to investors after a lag, often of weeks or even a month, meaning the extent of hedge funds’ gains is not yet clear.

But Danny Yong’s Singapore-based hedge fund Dymon Asia, which has been running the reflation trade since before the November presidential election, has also been profiting this week. “The ‘blue sweep’ will allow Biden to pass more aggressive stimulus spending,” said Mr Yong.

Also likely to gain is Brevan Howard, the hedge fund firm co-founded by billionaire Alan Howard. It has been positioned to benefit from a rise in long-term Treasury yields, according to an investor letter. It is also positioned to profit from a falling dollar, which many commentators expect to weaken if Mr Biden’s policies expand the US budget deficit.

Strategists at Wells Fargo reckon benchmark 10-year yields could climb to 1.2 per cent by the end of the month. By year end, Kathy Jones, chief fixed-income strategist at Charles Schwab, sees yields potentially rising as high as 1.6 per cent.

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