Evening Brief – 09.29.23
Treasury Basis Trade: Central Banks are Watching
The Bank for International Settlements (BIS) recently became the fourth institution to raise concerns about hedge funds’ accumulation of leveraged short positions in US Treasury futures contracts.
Since May, the US Securities and Exchange Commission, the Federal Reserve, and the Bank of England have all cautioned that these Treasury basis trades have the potential to severely destabilize financial markets
According to the BIS, leveraged funds have amassed around $600 billion in net short positions in US Treasury futures, with more than 40% of net shorts concentrated in 2-year contracts.
A Treasury basis trade is an arbitrage trade that uses price differences between Treasury futures and Treasury cash bonds to profit. When futures are trading rich (expensive) relative to cash, hedge funds attempt to profit by selling futures and buying cash bonds. Given that this basis is so minimal, hedge funds must use a lot of leverage to increase their payouts.
The process is as follows: hedge funds purchase Treasury bonds, then transfer them to a repo desk to acquire financing, which they keep. They then sell Treasury futures contracts.
When the futures contracts mature, hedge funds deliver Treasury bonds to settle their short futures bets. They finish the financing leg with the payout and keep the difference as profit.
The problem emerges when volatility in the Treasury market spikes unexpectedly (as it is right now), pushing hedge funds to liquidate and deleverage simultaneously. This was evident in early 2020 and earlier this year, with the failure of Silicon Valley Bank.
The illiquidity and disruption in the Treasury market were severe enough that the Fed intervened to inject liquidity and restore order. The BIS warns that leveraged funds are now at a comparable level of net shorts.
Another important source of concern is the volume of Treasury issuance entering the market. According to Goldman Sachs, $2.7 trillion in 10-year comparable issuance is projected next year, up from $2.3 trillion this year (for more on Treasury issuance, see Thursday’s Evening Brief).
It’s also worth mentioning that the political impasse over the debt ceiling prevented the US Treasury from issuing paper this year. After Congress raised the debt ceiling in early June, a major amount of this issuance is occurring in the second half of this year.
The risk is that if more Treasury paper is issued, the current trend of asset managers going long and hedge funds shorting Treasury futures (via the basis trade) will continue, and any unforeseen occurrences will trigger a repetition of the 2020 and March 2023 scenarios.
In the current context, two possibilities could require hedge funds to quickly unwind their basis trades: one if the market moves against them, such as if their repo position becomes too expensive to roll. Another possibility is that bond market volatility causes them to post higher margins on their short Treasury bond bets.