The Hedge Fund Unwinding: Short Position Against Gilts at Record Low Since 2006

Introduction

In the ever-changing sphere of financial markets, where sentiments change with the wind, a significant development has caught the attention of investors and economists alike: the record low in short-positions against UK government bonds. This shift has sparked conversations across the board, especially due to the insights it provides into the economic landscape of the country. This article will dive into the factors behind this shift and explain the short position more generally.

Understanding Short Positions

Before explaining the drop in short positions against gilts, understanding what short positions are and their importance in the realm of finance is imperative. A short position is a bet against an asset’s price. Short-sellers aim to make a profit and bet on the fact that the asset’s price will fall: they borrow an asset, such as gilts, and sell at the current market price, wishing to buy them back at a lower price and hence attaining a profit margin.

Shorting is indicative of market and investor sentiment. An increase in overall short positions, more often than not, implies a lack of confidence in the future performance of the asset, or the opinion that it is overvalued at its current price.

Historically, shorting gilts has been a game of fluctuations, with the biggest surges in 2016/17 during Brexit and 2021 during BoE’s attempt to control inflation. With the current climate, the drastic unwinding of short positions by hedge funds does not come as a surprise.

The Current Climate

According to S&P Global, shorting positions against government debt have fallen to a record low since 2006 in the UK. Shorting refers to a wager by investors on the fall in price of a particular asset; the investor will profit if the price of the asset falls.

The drop in short positions to below £65 billion has taken place right as gilts – UK government bonds – have had their comeback. The yield gilts attain have a direct correlation with inflation and interest rates: as long as interest rates stay high and inflation continues, gilt yields will rise. Within the past month, gilts have risen by 2.7% (Ice Bank of America index).

Reasons:

  1. Markets have priced in a 60% probability that there will be one more rise in rates to 5.5%. A peak rate of 6.5% was predicted in June

  2. A softening labour market

  3. There is an improvement in domestic inflation, with CPIH annual inflation at 5.9% this August. This is down from 6.5& in May at which point it had hit a record high since 1991. However, the all goods index has risen by 6.3%.

  4. The Bank of England expects inflation to be at 5% by the end of 2023 and September marked the first month that the central bank held out the interest rate at 5.25%. However, it has not ruled out another increase in rates and emphasizes it will not be “complacent” in its management of inflation.

  5. Chances of recession have increased due to low economic activity

Conclusion

This record low in short positions against UK government bonds is a significant occurrence in the fixed-income markets. It is indicative of the ever-changing economic conditions, investor sentiment and central bank policies. Although the unwinding of short positions implies some confidence in the country’s path to recovery, continuous monitoring of the economic situation is imperative. What’s true today could be false tomorrow.

Written By Ujjwala Singh