The most popular trading strategy among hedge funds in the U.S. bond market is showing signs of reaching its capacity limit.
This strategy, known as the basis trade, primarily bets on the tiny price differences between U.S. Treasury futures and the corresponding cash bonds, using large amounts of borrowed money to amplify returns. But now, these price spreads are narrowing, and the momentum behind the trade is weakening.
There has been a decline in trading activity in the repo financing market, which hedge funds often use to obtain leverage, and short positions in Treasury futures are also decreasing, suggesting the basis trade is receding. Morgan Stanley estimates that in recent months, the amount of capital leveraged investors have put into the basis trade has shrunk by over $200 billion, falling to $1 trillion.
Morgan Stanley U.S. interest rate strategist Eli Carter said, "The growth in the scale of the basis trade has stalled, indicating that its capacity has almost reached its limit."
Goldman Sachs Group U.S. repo business head Chris Horvatin stated that some of his clients complain the basis trade "is dead" and no longer offers many attractive opportunities.
To be clear, this trillion-dollar strategy is still enormous. But the key is the growth momentum, which, at least for now, is slowing down.
Multiple factors have contributed to this change. Some point to an increase in U.S. Treasury holdings by Wall Street banks. After years of shrinking their balance sheets, banks are re-entering this market in a big way. Others believe that this year's decline in U.S. bonds has cooled asset managers' demand for Treasury futures. Additionally, the U.S. government's financing structure is shifting more towards short-term T-bills, and the Federal Reserve has stopped shrinking its balance sheet.
These changes reduce the mispricing available for hedge funds to exploit in the bond market, diminishing the incentive for them to make large bets. Traditionally, the main participants in this strategy include large macro hedge funds and multi-strategy giants like Millennium Management, ExodusPoint Capital Management, Citadel Investment, and Capula Investment Management. Representatives of these companies all declined to comment.
If this trend continues, it could reshape the $31 trillion U.S. Treasury market. In recent years, the market has increasingly relied on hedge funds to provide liquidity and maintain smooth operation.
It is this dependence that has led regulators to issue warnings several times over the years. During the market turmoil in March 2020, massive unwinding of basis trades by hedge funds exacerbated market volatility, eventually forcing government intervention. Whether this shift in the balance of power will create new risks remains to be seen.
Under Pressure
The basis trade is built on the fact that U.S. Treasury futures prices tend to be higher than those of the underlying bonds. This occurs mainly because asset managers prefer to take on interest rate risk through derivatives rather than by directly holding bonds. Additionally, uncertainty about which bond will become the "cheapest to deliver" creates trading opportunities.
Morgan Stanley's Carter noted that from both perspectives, basis trade opportunities are "under pressure." As more capital enters the trade to go long on the basis, the returns from this strategy will eventually become less attractive.
Carter and other analysts point out that data from the U.S. Commodity Futures Trading Commission (CFTC) shows a decline in the net short positions of leveraged funds across various U.S. Treasury futures contracts, indicating a reduction in their basis trade positions. Meanwhile, trading volumes in the sponsored repo business of the Fixed Income Clearing Corporation (FICC) have also decreased. This mechanism allows dealers to intermediate between cash lenders and hedge fund borrowers without putting the transactions on their own balance sheets.
Another factor is Wall Street's re-entry into the U.S. Treasury market, driven by widespread deregulation under the Trump administration. In the financial sector, these measures primarily focus on relaxing rules that limit dealers' risk-taking capacity, including regulations related to the Treasury market.
Bank regulators have relaxed the so-called enhanced supplementary leverage ratio (eSLR) requirements. This may have paved the way for some dealers to increase their Treasury holdings this year. Banks' net long positions in Treasuries hit a record high earlier this year and are still far above last year's levels.
To hedge against the risk of falling bond prices, dealers can short U.S. Treasury futures. Although their motives and methods differ from hedge funds' basis trades, this creates similar cash flows, thereby compressing the spreads that the latter seek to exploit.
Barclays interest rate derivatives research head Amrut Nashikkar said, referring to banks' hedging activities, "When you hold a long position in U.S. Treasuries and simultaneously establish a corresponding short position in futures, from an economic effect perspective, this is equivalent to a basis trade, and it invisibly reduces the profit margins for other basis trade participants."
CFTC data also shows that asset managers have reduced their long positions in short-term U.S. Treasury futures contracts. This may reflect a reversal in the outlook for Federal Reserve policy since the end of February, following the attack by the U.S. and Israel on Iran. Traders now bet that the Fed's next move will be a rate hike, rather than the cut expected before the war. A decline in demand for going long on Treasury futures will narrow the premium of futures over cash bonds.
However, if economic conditions change and the market re-prices for rate cuts, driving up demand for futures, trading opportunities could quickly rebound. Other factors compressing the basis trade space may also ease as markets naturally fluctuate.
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