The next ‘pain trade’ could be on the horizon as investors crowd into bets pegged to Fed monetary policy

As traders brace for a series of interest-rate increases this year, starting in March, many could be caught flat-footed in crowded bets that are designed to profit from anticipated monetary policy moves, should market-based expectations suddenly shift.

Friday’s release of unexpectedly strong job gains for January is giving greater credence to a Fed rate increase next month that could be a bigger-than-usual 0.50 percentage point increase, while the likelihood that the central bank’s policy rate target could end the year between 1.75% and 2% also has risen, according to the CME FedWatch Tool.

The trouble is that the COVID-19 pandemic has cleaved the range of possible U.S. economic outcomes into two directions, which can change on any given day: One favors higher policy and market rates, as the Fed and other central banks attempt to tackle persistent inflation. The other supports the view of lower rates, on the basis that economies are too fragile to handle much tightening and inflation should subsequently trail off.

That leaves those positioned for higher U.S. policy rates exposed to potential losses if the market narrative suddenly flips.

“The consensus views in this market scare me,” Gang Hu, a TIPS trader with New York hedge fund WinShore Capital Partners, wrote in a note released after Friday’s jobs report. “Reading through various research papers from the Street, I couldn’t find anyone disagree with each other. But if we all agree and put on the same positions, who’s going to take us out” of the trade?

Friday’s robust nonfarm payroll report was met with rising Treasury yields, as the 10-year rate
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broke through 1.9%, stocks found their footing, and investors braced for a Fed that seems certain to move away from an easy-money stance, which has kept the fed funds pinned to current levels between 0% and 0.25%. Yet it was only a few months ago that some of the most sophisticated investors — hedge funds — were caught off guard by unexpected dovish pivots by the Fed and Bank of England, as well as a flattening of bond market yield curves.

Read: More pain likely for hedge funds as leveraged investors unwind wrong-way bond market bets, traders say

The unexpected nature of the pandemic has produced enough uncertainties to leave lingering doubts about the outlook, Hu told MarketWatch by phone — starting with the possibilities that a fresh wave of COVID-19 cases could re-emerge at any time and that growth might taper off, bringing inflation down with it. His views were backed by a Treasury yield curve, or spread between short-term yields and their longer term counterparts, that narrowed further on Friday, despite the surprisingly strong jobs report.

“We are all following central banks and taking whatever they tell us at face value,” he says. “But I expect they could probably tell us something different at another time.”

Exacerbating the risk ahead are the consolidations in the fund management industry, with fewer people controlling more money, getting all the same information, and making the same bets — with one financial firm crossing the $10 trillion threshold, according to Hu. With so few controlling so much, “who has the size to be their counterparty and take them out of the trade?” he wrote.

Read: BlackRock Now Manages Over $10 Trillion in Assets

The lack of adequately sized counterparties on the other side of a trade means unwinding that position becomes more costly. “You can execute, but if you are forced to sell, getting out can be a painful adjustment,” said head trader John Farawell with Roosevelt & Cross, a bond underwriter in New York.

Farawell pointed to Friday’s jobs report, which “shocked everybody,” as an example of how easily the herd can turn out to be wrong. “Now the question is if the Fed is going to do a 25 or 50 basis point hike, and when I see everyone looking the same way, a pain trade may occur. With many positioned for a flattening of the curve, it now could be a steepening that’s the next pain trade.”

The difficulty with being on the wrong side of a popular bet was highlighted late last year, when hedge funds incurred significant losses from wrong-way positions on the direction of interest rates in the U.S. and across the world. Their need to short-cover, or buy back securities to close out open short positions, was said to be one of the factors contributing to a decline in Treasury yields during early November.

An absence of market players may be occurring in other markets, such as crude oil
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resulting in bigger swings in prices. The crude-oil market has lost some players during the pandemic, particularly companies that once acted as “circuit breakers,” said Tom Kloza, global head of energy analysis for the Oil Price Information Service. So several exploration and production firms have said they won’t hedge in futures, and “fewer participants translate into more volatility,” Kloza said.

Investors now turn their attention to next Thursday’s consumer-price index report, which traders and economists expect to come at around a 7.2% year-over-year headline gain. Traders also expect the February reading to hit 7.4% and March to hit 7.2% before annual CPI starts to taper off down to 3.3% at the end of the year.

“There has definitely been binary ways to look at inflation as it affects the market, but there hasn’t been a dispersion of views as much as I would like,” said Rob Daly, director of fixed income at Glenmede Investment Management in Philadelphia.

“The next pain trade could come if inflation moderates more quickly than expected, and rates come off quickly, with the 10-year yield falling back down to 1.50% —hurting those that have been positioned for aggressive rate hikes,” he said via phone. “Or it could come from inflation staying durable and the unwinding of risk.”

— Myra P. Saefong contributed to this article