30-year US Treasury yields are approaching 6%, which could trigger a switch in the "cheapest-to-deliver" (CTD) bond for Treasury futures, forcing asset management institutions to sell futures and further intensifying the rise in long-end yields.
On Monday, the 30-year US Treasury yield rose to 5.70%, the highest since 2002. According to Bloomberg analysis, if the yield rises to around 6%, the CTD for long-term Treasury futures could switch from the current Treasury maturing in 2045 to one maturing in 2050.
Position data shows that asset management institutions have already been reducing net long positions in long-term and ultra-long-term Treasury futures in recent weeks.
How delivery rules amplify selling pressure
US Treasury futures are exchange-traded contracts that agree to buy or sell Treasuries at a specific price and date. They are widely used by investors to hedge Treasury positions and are also tools for leveraged funds to carry out popular strategies such as "basis trades." The contract allows shorts to choose delivery from a basket of eligible Treasuries, and traders select the one with the lowest delivery cost, namely the CTD, with the futures price then tracking that bond.
A rapid rise in yields changes the pricing relationships among bonds in the deliverable basket, causing the CTD to migrate toward longer-dated bonds. To keep portfolio duration targets stable, futures longs need to sell and shorts need to buy back; depending on the interaction between the two and the timing, this process could spill over into the cash bond market.
Strategists at BNP Paribas, including Guneet Dhingra, Sebastian Mauleon and Vincent Zhou, noted in a report that asset management institutions selling Treasury futures to respond to a CTD switch "may exacerbate the rise in long-end yields."
Long-term Treasury futures remain a pressure point
The market focus is on the long end, especially long-term Treasury futures contracts, whose current CTD is the Treasury maturing in February 2045 with a 2.5% coupon.
Barclays strategists Andres Mok and Amrut Nashikka said in a Monday report that investors "may need to reduce futures exposure or readjust hedge ratios to bring portfolio duration back to target levels," while "higher rates and volatility have increased uncertainty around the CTD outcome." They estimate that the total rebalancing demand from asset management institutions is about $25 million per basis point for long-term Treasury futures and about $3 million per basis point for ultra-long-term Treasury futures.
Ultra-long contracts see heavy selling
In recent weeks, as the 30-year yield rose sharply above 5.6%, asset management institutions simultaneously reduced net longs in both types of contracts. Goldman Sachs strategists George Cole and William Marshall believe this was very likely "actively managing duration extension risk related to a potential Treasury futures CTD switch."
Data from the US Commodity Futures Trading Commission (CFTC) shows that in the week ended September 29, as the 30-year yield rose from 5.28% to as high as 5.62%, asset management institutions cut net longs in ultra-long-term Treasury futures by nearly 100,000 contracts, equivalent to $15 million of risk per basis point, or $11 billion of current 30-year cash bonds. Over the same period, changes in long-term Treasury futures positions were more moderate, indicating that CTD switch risk and related passive selling pressure at that maturity still remain.
Sumitomo Mitsui Banking Corporation (SMBC) rates strategist Monty Gandhi said:
"Ultra-long-term Treasury futures have already switched to a higher-duration CTD, but long-term Treasury futures still have upside risk of duration extension."
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