The growth of one of hedge funds’ biggest trades in the US Treasury market is showing signs of slowing as narrowing price gaps and changing market dynamics reduce the appeal of the strategy, according to a report by Bloomberg.
The so-called basis trade exploits small differences between Treasury futures and the underlying cash bonds. Hedge funds typically use significant leverage, often funded through repo markets, to amplify relatively small returns.
Morgan Stanley estimates that the amount of capital tied up in leveraged investors’ cash Treasury basis positions has fallen by more than $200bn in recent months to around $1tn.
The strategy remains enormous, but the slowdown in its expansion is attracting increasing attention from investors and regulators given the role hedge funds play in the $31tn US Treasury market.
Some participants in the repo market have described the basis as offering limited opportunities. Chris Horvatin, a Goldman Sachs managing director who oversees the bank’s US repurchase agreement business, said some clients had been describing the trade as effectively “dead” because of the lack of attractive spreads.
The basis trade has historically benefited from the tendency of Treasury futures to trade at a premium to the cash market. Hedge funds can buy the bonds, short the futures and seek to capture the difference, with leverage allowing them to scale up what are often relatively modest returns.
However, several developments are now working against the strategy.
US banks have increased their Treasury holdings after years of maintaining relatively constrained balance sheets. To hedge the interest-rate risk associated with those positions, dealers may short Treasury futures, creating flows that can further compress the spreads basis traders are attempting to exploit.
The shift has followed changes to bank capital rules, including a relaxation of the enhanced supplementary leverage ratio, which has given some dealers greater capacity to hold Treasuries.
Bank net long positions in the market reached record levels earlier this year and remain significantly above last year’s levels, according to market analysts.
Meanwhile, asset managers have reduced long positions in shorter-dated Treasury futures, according to data from the Commodity Futures Trading Commission. Weaker demand for futures can reduce the premium over cash bonds that helps create the basis-trade opportunity.
The change in positioning has coincided with a shift in expectations for US monetary policy following the escalation of the conflict involving Iran. Traders have moved away from expectations of near-term rate cuts, with some now positioning for the possibility of higher interest rates.
Other market developments are also reducing the number of dislocations available to hedge funds. The US Treasury’s borrowing mix has shifted towards short-term bills, while the Federal Reserve has stopped shrinking its balance sheet, altering the supply and liquidity dynamics of the Treasury market.
Evidence of reduced activity is also emerging in funding markets used to support leveraged basis positions, while hedge funds’ net short positions in Treasury futures have declined.
The major participants in the strategy have traditionally included macro hedge funds and multi-strategy firms, including Millennium Management, ExodusPoint Capital Management, Citadel and Capula Investment Management.
Any sustained reduction in basis-trade activity could have wider implications for the Treasury market, which has increasingly relied on hedge funds to provide liquidity and absorb risk.
The strategy came under intense scrutiny after hedge funds rapidly unwound basis positions during the market turmoil of March 2020, contributing to severe dislocations and prompting regulators to warn about the risks created by highly leveraged trades concentrated across a relatively small group of market participants.
The current slowdown does not necessarily signal an imminent disorderly unwind. The basis could become more attractive again if economic conditions shift, including a renewed market consensus around interest-rate cuts that boosts demand for Treasury futures.
