The U.S. Treasury market is witnessing a rare capitulation among bullish investors.
On May 19, according to reports from trading desks, Bank of America Merrill Lynch's latest research indicates that bullish positions across the Treasury yield curve have largely surrendered, leaving only minimal out-of-the-money residual holdings. In contrast, bearish positions now dominate overwhelmingly, with most being in-the-money.
The bank's U.S. Rates Research team noted in its "U.S. Rates Watch" report that various capital flows—from systematic trend followers (CTAs) to global active asset managers, and Japanese private and official investors—are simultaneously adjusting their positions, either exiting or shorting U.S. Treasuries.
Commodity Trading Advisors (CTAs) have stretched their short positions to extreme levels, asset management institutions continue to increase shorts or unwind longs, Japanese private investors have been net sellers of U.S. Treasuries for two consecutive months, and potential yen intervention operations could introduce an implicit selling pressure of up to $40 billion to $50 billion.
However, behind this significant repositioning, rising yields are attracting a surge of capital back into the short end and credit markets.
Simultaneously, analysis points out that the "Sword of Damocles" hanging over the market is the potential for large-scale foreign exchange intervention by the Bank of Japan. If such intervention expands further and triggers official sales of U.S. Treasuries, the global fixed income market could face a genuine storm.
**CTAs and Asset Managers Fully Shift, Short Positions Approach Limits**
The reversal in market positioning has been exceptionally sharp. Data from BofA's Systematic Strategy team shows that CTA short positions across the entire yield curve have reached their limits. In recent weeks, the focus of shorting has shifted from the short end towards the long end.
Future positioning changes will heavily depend on volatility: if futures continue to decline due to falling volatility, short positions may expand further; however, if volatility rises, shorts are expected to retreat.
Meanwhile, global asset managers are also rapidly shortening their duration. Last week, asset management institutions primarily increased shorts or unwound longs, with net shorts rising across all maturities except for 20-year and 30-year Treasuries.
Active benchmark Aggregate funds are currently "underweight" U.S. Treasuries while remaining "overweight" mortgage-backed securities and investment-grade bonds.
The most significant change over the past month has been the increasing overweight allocation to investment-grade bonds. This spread overweight strategy has supported active funds' outperformance relative to Treasuries since early April.
**Japanese Capital Continues to Retreat, Shadow of Massive FX Intervention Looms Over Treasuries**
The dynamics of foreign investors add another layer of significant risk to the U.S. Treasury market, particularly the movements of Japanese capital.
Data from Japan's Ministry of Finance shows that after selling $18 billion in February, Japanese private investors continued to be net sellers of U.S. Treasuries in March, offloading $14 billion. Banks led the selling, with pension funds and life insurance companies also actively participating.
The core reason is that for Japanese investors, even after three-month rolling FX hedging, the yield on 10-year U.S. Treasuries remains deeply negative compared to Japanese Government Bonds.
More concerning to the market is the potential for official Japanese FX intervention. BofA FX strategists estimate that recent suspected yen-supportive intervention may have involved approximately $72 billion, potentially the largest since 2022. This implies an implicit U.S. Treasury selling pressure possibly reaching $40 billion to $50 billion.
Although data from the Federal Reserve's foreign reverse repo facility and custody holdings as of the week ending May 13 do not yet show clear evidence of large-scale official liquidation, the source of intervention funds remains a mystery.
BofA warns that if further yen intervention requires selling close to $100 billion of U.S. Treasuries, it would have a material impact on the Treasury market, equivalent to the decline in custody holdings seen at the onset of the Iran conflict, posing a significant headwind for front-end spread positions.
**Soaring Yields Trigger Massive Capital Migration, Short Duration Becomes the Absolute Safe Haven**
Despite the overall bearish positioning, capital flows reveal another dimension of market tension: higher yields are attracting capital back into the market.
As duration is being sold off, fund inflows have actually accelerated. Last week, U.S. fixed income funds attracted a substantial $18 billion, double the average of the past 12 weeks.
However, capital is not flowing in blindly. Inflows were primarily led by Aggregate, short-term government bond, and investment-grade bond funds, while long-term government bond funds were the only category to experience outflows.
This notable divergence indicates that investors are rapidly shortening their weighted average maturity as the market reprices Federal Reserve rate hike risks.
It is worth noting that amid the retreat of bulls and foreign selling, primary dealers and U.S. domestic banks are absorbing the supply.
Data shows dealers' balance sheets are expanding, with their long-end holdings in both spot and futures markets increasing significantly. Simultaneously, U.S. domestic banks have accelerated their accumulation of U.S. Treasuries and agency debt in recent months, outpacing their accumulation of MBS.
Furthermore, the traditional large buyer in fixed income markets—defined benefit private pensions—currently remains in a healthy funding position. Historical patterns suggest that when funding status improves and rates rise, pension funds tend to purchase more Treasuries.
However, April data shows that Treasury STRIPS activity has retreated from its peak at the end of 2024 and is below historical averages, hinting that the momentum from this segment of long-term buying is marginally slowing and may be insufficient to fully offset the current selling frenzy.
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