Morgan Stanley strategists have pointed out that the scale of the U.S. Treasury basis trade has now ballooned to approximately $1.5 trillion, highlighting the necessity of closely monitoring its size to avoid a repeat of the severe market volatility witnessed in 2020. This trading strategy, predominantly employed by hedge funds, centers on capturing the minuscule price differentials between the cash market for U.S. Treasuries and the futures market. The bank's calculations indicate that the scale of this strategy has grown by 75% compared to its 2019 peak, with the expansion rate of its nominal trading volume in recent years surpassing the growth rate of U.S. Treasury issuance. Strategists, including Eli Carter and Shaun Zhou, stated in a research report released on Tuesday that the current level of trading activity is "not unprecedented" but still requires vigilant monitoring, especially during periods of tightening funding conditions or market turbulence. The inherent nature of the trade means that if hedge funds are forced to unwind their positions rapidly, bond dealers may lack the capacity to absorb the surge in trading volume within a short timeframe. Morgan Stanley emphasized that the associated risks are currently highly concentrated in 5-year Treasury futures contracts, followed by ultra-long-term and 10-year contracts; in recent years, risk exposure has also been persistently increasing in the middle segment of the yield curve. In 2020, the cash market for Treasuries underperformed the futures market, creating conditions diametrically opposed to those required for the basis trade to be profitable. This led to substantial losses for hedge funds and contributed to the market volatility of that period. At that time, the Federal Reserve was compelled to intervene, purchasing trillions of dollars worth of bonds to stabilize market functioning and injecting emergency liquidity into short-term lending markets, such as the repo market. Notably, the total scale of this trade in 2020 was only about $500 billion, merely one-third of its current size. Currently, global regulators are intensifying their scrutiny of this trading activity. Both the Bank of England and the Basel-based Bank for International Settlements have issued warnings that the leveraged operations of a few large hedge funds could pose a potential threat to financial stability.
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