Where next for hedge funds’ Treasury basis trade?

^{By Hugh Leask}

As hedge funds have piled into the so-called basis trade in U.S. Treasury markets this year, aiming to capitalize on the pricing gap between Treasury futures and the underlying cash bonds, the bet has emerged as a key regulatory flashpoint, sharpening divisions between the hedge fund industry and policymakers.

Hedge fund pros consider the long-running trade a relatively low risk arbitrage call that looks to take advantage of the price divergence of cash treasuries and the corresponding futures contracts. Here, strategies including global macro and relative value fixed income take short positions in U.S. Treasury futures, while going long the cash bonds, transferring them to a repo desk for financing. Once the futures mature, hedge funds deliver the Treasury bonds to settle their short future positions, close the financing leg, and keep the difference as profit.

While the price differential between the two is relatively small, managers have levered up their positions to help inflate returns from some 20 basis points towards 5% or more. That, in turn, has heightened fears among market authorities that any unforeseen event could spark a re-run of the turmoil that tore through markets in early 2020 and March 2023.

As managers and investors grapple with sustained uncertainty around the higher-for-longer rate environment, looming recessionary concerns, and a renewed regulatory focus on financial stability, how is the bet likely to play out into 2024?

Arbitraging anomalies

Market practitioners told Alternatives Watch the Treasury basis trade has gathered momentum among hedge funds that have filled the void left by investment banks that reduced their balance sheets in the years following the 2008 Global Financial Crisis.

According to the Managed Funds Association, the basis trade benefits the Treasury market by lowering the overall cost of government borrowing by creating demand for U.S. Treasuries, while increasing liquidity, tempering volatility, and reducing bid-ask spreads. The MFA noted hedge funds are constrained in how much leverage they can ultimately utilize, partly because the futures contracts they are shorting against their cash Treasury longs have sizable initial margin requirements.

But against a backdrop of sustained rate tightening during the past 18 months, leveraged strategies have ramped up their basis trade bets at pace, amassing a sizable $650 billion in net short positions in U.S. Treasury futures over the summer, according to Bank of International Settlements estimates. More than 40% of the net shorts are concentrated in two-year contracts.

As a result, the Securities and Exchange Commission, the Federal Reserve, and the Bank of England have all raised concerns that any rapid unravelling of so many heavily levered short positions at once could potentially destabilize markets.

For hedge funds, the main risk is that the spread widens from the point of entry and any variability on the various legs of the trade, such as the cash bond, the repo stage, or the short futures. A messy unwinding could arise from either a repo position becoming too punitive to roll, or if bond market volatility required more margins for short Treasury bond positions, market professionals explained.

Yet Federal Reserve analysis shows hedge funds’ role in the March 2020 Treasuries turmoil was relatively minor compared to other market participants: while foreign investors sold $400 billion of Treasuries, and mutual funds offloaded more than $200 billion, hedge funds by comparison sold just $35 billion.

Jim Neumann, partner and chief investment officer at hedge fund advisory Sussex Partners, said arbitraging out anomalies is vital for market functioning.

“The real question, that should be the focus, is the amount of money that can be lost at each fund and combined if the market freezes up and margins are increased where not locked,” Neumann told Alternatives Watch. “Since ultimately the futures contract and the cash Treasury must converge, as long as the funds can hold the position, they are only subject to P&L volatility. Clients should focus on sound risk management around size, repo - bi-lateral and sponsored – cost, margin, and roll, and liquidity.” 

What next?

Looking ahead, a key concern up ahead is the growing pipeline of Treasury issuance. A recent market commentary by Man Group pointed to an estimated $2.7 trillion of 10-year equivalent issuance next year, outweighing the $2.3 trillion 10-year equivalent for 2023.

The SEC is now mulling range of options to tackle what is sees as heightened risks stemming from the various points of the basis trade. That has drawn criticism from across the industry, including Ken Griffin, founder and CEO of $62 billion Citadel, who last month told the FT that moves which risk “recklessly” impairing the basis trade would “crowd out funding for corporate America.”

Griffin’s firm was one of several high-profile hedge funds including ExodusPoint Capital Management and LMR Partners that suffered steep basis trade-related losses during the March 2020 maelstrom.

SEC proposals include expanding the scope of its dealer rules, regulating hedge funds’ and other private funds’ Treasury market activities in ways similar to how they oversee investment banks’ broker-dealer units, and placing restrictions on bilateral uncleared repo in order to limit the use of basis trade leverage, effectively capping the juiced-up returns sought by managers and their investors.

However, industry advocates warn against the introduction of heavy-handed rules further down the line.

The MFA, which has more than 170 member firms spanning hedge fund, credit and crossover funds, accounting for $3 trillion in AUM globally, said in a market primer that policymakers should not “radically change” the Treasury market structure without first understanding the consequences of such major modifications.

It also highlighted the Fed’s annual Financial Stability Report, published in October, which found that basis trade risks are mitigated by “tighter financing terms applied to hedge funds by dealer counterparties over the past several quarters.”

Instead, the trade group is calling for “gradual, thoughtful, data-driven” reforms to address changing Treasury market dynamics, including the expansion of voluntary central clearing for both secondary cash transactions and repos; cross-margining for end-users for Treasury futures and cash Treasury transactions; improving data and transparency, including the reporting of repo and reverse repo transactions to a central depository.

Tug of war

Elsewhere, the ongoing “tug of war” between the terminal rate of the central banks and the probability and timing of a slowdown or recession – which would herald interest rate cuts – remains in sharp focus for arbitragers.

“The U.S. rates market had been oversold by most measures and certainly global macro and trend following systematic managers were net short in size across the curve,” Neumann said. 

“The battle is also being waged along the curve as the ‘higher-for-longer’ mantra was seen as a signal to push longer maturities higher, steepening the curve, making it less inverted. The rally triggered by the Israeli-Hamas conflict, has likely stopped out some of these trades or at least decreased the short-bias.”

He added: “All this movement is causing a lot of dislocation in the rates market which eventually provides fodder for relative value specialists to put on favorable risk/reward profile trades.”

_{This article, “Where next for hedge funds’ Treasury basis trade?” was originally published on December 5th, 2023 on Alternatives Watch and is republished here with permission from BMV Digital, Inc.}