By Anirban Sen and Gertrude Chavez-Dreyfuss
NEW YORK, Sept 24 (Reuters) – Like Treasuries themselves, the Treasury basis trade has fallen out of favor lately.
Funds locked up in leveraged basis trades are down 20% this year to $1.2 trillion, Morgan Stanley estimates. The decline reflects a mostly uneventful rise in US interest-rate expectations and improved trading conditions, both of which tend to limit the trade’s profitability.
The Treasury basis trade – in which hedge funds borrow overnight to profit on the narrow price difference between Treasury securities and futures – has been blamed for accentuating past market declines through margin calls and fire sales, mostly through the heavy borrowing funds use to boost returns.
But this year’s Treasury selloff has reflected in part softer demand for both Treasury securities and futures. Meanwhile, Treasury inventories at large securities-dealing banks are higher, thanks to a rule change, and the buybacks orchestrated by Treasury Secretary Scott Bessent have raised prices for so-called off-the-run, or older, bonds, further eating into potential gains.
“The basis position in the market has been declining because the opportunity set is lower,” said Meghan Swiber, US rates strategist at Bank of America. “The other part of this is that asset manager demand for Treasury futures has also been moderating.”
DEMAND FOR RATE-SENSITIVE ASSETS
Basis trading is driven in part by the demand among asset managers such as mutual funds for long-term Treasury holdings that they can use to boost the “duration,” or interest rate sensitivity, of their portfolios, analysts say.
Hedge funds plying the trade typically buy cash Treasuries, while simultaneously hedging that exposure by selling the corresponding futures to asset managers who will end up holding them. Hedge funds then deliver the cheapest Treasury security to the asset manager to eventually settle the trade.
The Treasury basis trade spans the entire yield curve, analysts said, with significant activity in the 2- and 5-year sectors as well as the benchmark 10- and long-end futures.
LOWER-DURATION PULLBACK
So far, the pullback has been mostly contained to futures that are tied to 2-year and 5-year maturities at the front end of the yield curve, according to Morgan Stanley analysts. Prices of short-term Treasuries are most vulnerable to rising Federal Reserve rate-increase expectations. Eli Carter, fixed income strategist at Morgan Stanley, pointed out that hedge funds find it more difficult to enter the basis trade when there is reduced demand for long positions from asset managers, especially at the front end of the yield curve.
Both hedge funds and asset managers have pared back positions in US 2-year Treasury futures in recent months. Hedge funds’ net short positions have fallen by more than 40% from a 15-month high reached in March and are down more than half from the record level seen in December 2024, according to the latest CFTC Commitments of Traders data.
On the other side of the trade, asset managers’ net long positions have declined by more than 30% from an all-time high reached in March.
To be sure, hedge funds still hold a significantly large position in the basis trade, according to experts and portfolio managers that Reuters interviewed. The exposure of large hedge funds to Treasury holdings has recently triggered questions about systemic risks in the market from the New York Federal Reserve, according to two people familiar with the matter. The Wall Street Journal reported the discussions earlier.
According to a 2024 paper by investment professional Steven T. Williams, the market could face shocks if rates were to suddenly reverse, due to an imbalance stemming from the duration shortfall for mortgage-backed securities held by asset managers, who are big buyers of Treasury futures.
But in the current cycle, neither rising participation from broker-dealer arms of banks nor higher Treasury yields has yet produced evidence of broad market stress related to the basis trade, according to Morgan Stanley.
“While returns have become less attractive and notional has declined, we think the trade remains alive and well,” Morgan Stanley analysts said.
SLR REFORMS
Large leveraged Treasury positions have attracted greater scrutiny recently as several large pension funds from across the world have cut their allocations towards Treasuries over the past year. Multi-strategy funds like Citadel, Millennium, and Balyasny Asset Management have over the years emerged as big players in the Treasury market.
Meanwhile new regulations adopted at the end of last year have made it easier for broker-dealer arms of banks to buy Treasury bonds.
The loosening of the so-called supplementary leverage ratio (SLR) requirements has allowed large banks and dealer desks to hold more Treasury inventory — which some experts say has increased liquidity.
Prior to the SLR reform, Wall Street broker-dealer desks were restricted in their ability to hold large inventory, thus creating price dislocations in the Treasury market — which basis traders have traditionally taken advantage of.
“When dealers’ ability to hold Treasury inventory increases — and it has — what that naturally does is that it reduces the relative value opportunity for the basis trade because these positions are also hedged in the futures market,” said Amrut Nashikkar, head of interest rate derivatives strategy at Barclays.
(Reporting by Anirban Sen and Gertrude Chavez-Dreyfuss in New York; Editing by Colin Barr and Andrea Ricci )
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