Trend-following investors have built a record level of short positions on global bonds, making this week's US inflation report a critical inflection point. Data from UBS Group shows that commodity trading advisors (CTAs), which aim to profit from price movements in various asset classes, tripled their underweight bond positions in July compared to two weeks prior. These bets have since remained stable, but if the upcoming US consumer and producer price indices trigger a rise in Treasury prices, these CTA trades face the risk of losses.

According to strategist Nicolas Le Roux, ahead of the inflation data release, every one basis point move in the 10-year Treasury yield translates to a profit or loss of approximately $300 million for CTAs. This exposure is the largest since UBS began compiling the data in 1990. Source: UBS Group

In recent months, global government bond yields have been slowly climbing, driven by high oil prices, market expectations of central bank rate hikes, and concerns over a surge in government borrowing. The US 30-year Treasury yield last month rose to its highest level since 2007 and has remained near that peak. The bond sell-off has prompted CTAs to add to their short positions in line with the trend. CTAs manage an estimated total of over $400 billion in assets.

However, the heavily one-sided positioning also carries risk; if bonds begin to rally, CTAs might be forced to rapidly unwind their shorts. Phoebe White, Head of US Interest Rate Strategy at UBS, stated, "There is limited room to add further to short positions. The risk is clearly asymmetric. If bonds rally, traders are more likely to cover shorts, whereas if bonds continue to fall, the potential for them to add more is relatively low."

A major test arrives on Wednesday. The Consumer Price Index (CPI) report could either reinforce or weaken the case for a Federal Reserve rate hike as early as September, potentially forcing traders to readjust their positions. Interest rate swaps indicate the market currently sees the probability of a 25-basis-point hike next month as nearly a coin toss.

Following a weaker-than-expected jobs report on Friday, White and her colleagues advised clients to buy two-year US Treasuries. In addition to signs that inflation may have peaked, White believes the crowded short positions could support a rally in government debt. Strategists at Bank of America have also identified significantly bearish CTA positioning, noting the group remains "heavily short," particularly in shorter-dated bonds, which makes Wednesday's inflation report especially important. Bank of America strategists, including Meghan Swiber, wrote in a note on Monday, "If the data does not support a September rate hike, it could challenge the crowded short positions, especially given the large CTA short and active funds also being underweight."