Hedge Funds’ Favorite US Bond Trade Is Sputtering
(Bloomberg) -- Hedge funds' most popular trade in the US bond market is showing signs of maxing out.
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Known as the basis trade, the strategy involves wagering on the small price difference between Treasury bond futures and the underlying securities, using heaps of borrowed cash to scale up the bet. But now those gaps are narrowing, and the trade is losing steam.
Early evidence of a pullback can be seen in reduced activity in some of the repo funding markets commonly used by hedge funds to obtain leverage, combined with a decline in their short futures positions. Morgan Stanley estimates the amount of money locked up in leveraged investors' basis trades has declined by more than $200 billion to $1 trillion in recent months.
"The stalled growth rate in the size of the basis trade suggests that we've almost reached max capacity," Eli Carter, a US rates strategist at Morgan Stanley, said.
Chris Horvatin, a managing director at Goldman Sachs Group Inc. who oversees the bank's US repurchase agreement business, said some of his clients were "bemoaning that the basis is 'dead' and not really offering that much of an attractive opportunity."
The trillion-dollar strategy, to be clear, is still colossal. But it's the momentum that matters. And, at least for now, it's slowing.
A myriad of factors are at play. Some point to an increase in Treasury bond holdings by Wall Street banks, which have been piling back into the market after years of keeping their balance sheets lean. Others cite a cooling in demand for Treasury futures by asset managers amid this year's selloff. Then there are the shifts in US government borrowing, which has been tilting toward short-term bills, and the Federal Reserve no longer shrinking its balance sheet.
All of this leaves fewer bond-market dislocations for hedge funds to exploit, and less incentive to go all-in. The strategy's major players have traditionally included large macro hedge funds and multi-strategy giants like Millennium Management, ExodusPoint Capital Management, Citadel and Capula Investment Management. Representatives for these firms declined to comment.
The dynamic, should it continue, has the potential to shake up the $31 trillion market, which in recent years has increasingly relied on hedge funds to provide the liquidity to keep markets operating smoothly.
That very reliance sparked multiple warnings from regulators over the years and prompted the government to step in as a backstop in March 2020 when hedge funds furiously unwound basis trades in the face of market turmoil, adding to the turbulence. Whether a shifting balance portends a fresh set of risks remains to be seen.
The basis trade is predicated on a tendency for Treasury futures to trade at a premium to the cash market, a byproduct of asset managers' preference to take on interest-rate risk using derivatives instead of the underlying bonds. Uncertainty over which bond will be the cheapest to deliver — the Treasuries that are the least costly to settle expiring futures contracts — can also create opportunities.
On both counts, basis trade opportunities are "under pressure," Morgan Stanley's Carter said. "At some point, the returns in this trade become less attractive as you have more and more money entering into long basis positions."
He and other analysts point to Commodity Futures Trading Commission data showing a decline in leveraged funds' net short positions in various US Treasury future contracts as evidence of their reduced basis positions. That's alongside lower volumes in the Fixed Income Clearing Corporation's sponsored repo offering, which lets dealers intermediate cash between lenders and hedge‑fund borrowers without taking the trades onto their own balance sheets.
One contributor is Wall Street's renewed push back into the Treasuries market, triggered by the Trump administration's vast de-regulation campaign. In finance, that has focused on loosening rules that had limited the amount of risk dealers could take, including in the Treasuries market.
Bank regulators eased what's known as the enhanced supplementary leverage ratio. That may have paved the way for some dealers to boost their Treasury holdings this year. Net long positions reached an all-time high earlier this year, and remains well above last year's levels.
To hedge the risk their bond holdings fall in price, dealers can short Treasury futures. While that's a different motivation and mechanics from hedge funds' basis trades, it's a similar flow that can compress the spreads they're seeking to exploit.
"When you have a long Treasury position and you have a short future position against it, that's economically equivalent to a basis trade," Amrut Nashikkar, head of interest-rate derivatives research at Barclays Plc, said of banks' hedging activity. "And economically, that results in less profitability for those pursuing the basis trade."
Asset managers, too, have trimmed their long positions in front-end Treasury contracts, according to CFTC data. That may reflect the flipped outlook for Fed monetary policy since the US and Israel attacked Iran in late February, with traders now betting the next move will be an interest-rate hike rather than the cuts expected pre-war. Reduced demand for long futures positions can minimize the extent contracts trade at a premium to cash bonds.
To be sure, demand could quickly reignite should economic conditions change and expectations for rate cuts replace bets on hikes, prompting demand for futures. Other forces compressing basis-trade opportunities may also ease as part of a natural ebb and flow.
For Barclays' Nashikkar, the declining reliance on hedge fund leverage reduces the risk of "destabilizing feedback loops" in stressed environments.
"When you have greater diversity of market participants, the chances of a simultaneous unwind happening is lower," he said. "As a result, the Treasury futures basis trade has likely become less systemically fragile."
--With assistance from Hema Parmar and Alexandra Harris.
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