Hedge Funds Scale Back US Treasury Basis Trade to Over Two-Year Low

A once-popular trade in U.S. Treasuries has shrunk to its lowest level in more than two years, with Wall Street strategists attributing the decline to a reduction in market dislocations available for hedge funds to exploit.

The strategy, known as the basis trade, helps generate demand for U.S. government debt and provides liquidity to the $32 trillion Treasury market. It relies on significant borrowed capital to bet on small price differences between Treasury futures and the underlying securities.

As these spreads have narrowed, the trade has lost momentum, potentially removing a key source of funding from the market. While sudden liquidity tightening in the past has triggered financial market turmoil, strategists at banks including Morgan Stanley and Citigroup say the trade is far from disappearing, and the shift in momentum merely reflects fewer relative-value opportunities.

“The basis trade is shrinking as dislocations and volatility have declined significantly over the past few years,” said Jason Williams, head of U.S. interest rate strategy at Citigroup. “Fewer opportunities don’t signal risk; they may instead indicate that underlying demand for U.S. Treasuries is stronger than expected.”

According to Morgan Stanley, the total notional size of leveraged investors’ U.S. Treasury basis trades has fallen from $1.26 trillion at the start of the year to approximately $900 billion. A team led by Eli P. Carter at Morgan Stanley wrote that the decline reflects reduced returns on contracts tied to short-term Treasuries, as arbitrage opportunities have narrowed. They noted that basis trades involving long-dated bonds and futures remain popular, and there is no evidence that the reduced activity has caused market stress.

As the market has grown, the U.S. Treasury market has become increasingly reliant on hedge funds to provide liquidity and maintain smooth functioning. In recent years, their favored strategy has been the basis trade, in which funds typically buy spot bonds and sell the corresponding futures contracts.

The popularity of this strategy has long drawn warnings from regulators about the risk of a sudden shift in demand. This was evident in March 2020, when hedge funds frantically unwound basis trades amid market turmoil. The market only stabilized after the Federal Reserve stepped in with bond purchases and repo interventions.

Morgan Stanley strategists wrote that extreme volatility or short-term market stress in U.S. Treasuries could lead to a potential unwinding of hedge fund basis trade positions. However, they added that they are “comfortable with the current resilience of the trade,” citing its stability during recent periods of turbulence, while the repo market remains flush with cash.

This year, asset managers have reduced their net long positions in shorter-dated Treasury futures contracts, as the Federal Reserve’s monetary policy outlook shifted from expected rate cuts to anticipated rate hikes following a surge in oil prices. Weaker demand for futures has narrowed the spread between futures and the underlying bonds. The Morgan Stanley team said: “Weaker futures demand from asset managers has reduced potential arbitrage opportunities.”

Carter noted that the decline in basis trade positions has been concentrated in the two-year and five-year segments of the Treasury curve. For futures contracts tied to bonds maturing in 25 to 30 years, basis positions have increased, suggesting “no evidence of impaired hedge fund demand for Treasuries or overall stress in the basis trade.”

According to Citigroup’s Williams, changes in net Treasury supply—including the Treasury’s buyback of less-active bonds and the Federal Reserve’s halt to its quantitative tightening program—have also curbed arbitrage opportunities. Additionally, banks have shown a greater willingness to hold bonds. Increased demand for Treasuries has helped contain the dislocation between futures and underlying securities, reducing the appeal of the basis trade.

“The trade has performed well and is naturally self-correcting,” said Aga Mirza, global head of interest rates and over-the-counter products at CME Group. “A reduction in trade size due to relative-value economics does not affect the overall level of yields.”

Source: Bloomberg