Hedge funds pull back from Treasury basis trade as amid ongoing selloff

Hedge funds are reducing participation in the US Treasury basis trade due to diminishing returns and evolving market conditions, according to a Reuters report. The capital invested in leveraged basis positions has declined by about 20% this year to around $1.2tn, as stated by Morgan Stanley. This downturn occurs as expectations for US interest rates have climbed steadily, and trading circumstances have become less favorable for generating the spreads required by the strategy.

Treasury basis trading generally entails hedge funds purchasing Treasury securities while simultaneously shorting related futures contracts, utilizing short-term borrowing to finance the cash-bond positions and aiming to capitalize on the slight price difference between the two instruments, thereby magnifying returns. The approach has faced criticism during times of market turmoil due to the substantial borrowing utilized by hedge funds, which can make positions susceptible to margin calls.

Consequently, forced sales of Treasuries can exacerbate market declines when liquidity tightens. However, the present retreat is primarily attributed to a less appealing opportunity set rather than an uncontrolled unwinding of positions. Treasury prices have faced pressure throughout the year as demand for both cash securities and futures has waned.

Additionally, major securities dealers are maintaining larger Treasury inventories following a regulatory shift, while government buybacks have bolstered prices for older, or off-the-run, securities. These factors have diminished some of the price discrepancies that basis traders aim to capitalize on. The strategy depends on mutual funds and other asset managers seeking long-dated Treasury exposure to boost the duration of their portfolios.

Hedge funds can accommodate this demand by acquiring cash Treasuries and selling the corresponding futures contracts, with the cheapest eligible security typically employed to settle the transaction. Basis trading is active across the Treasury curve, with positions particularly concentrated in the benchmark 10-year and longer maturities, as well as the two-year and five-year sectors.

The current decline in activity has been most significant in futures linked to two- and five-year Treasuries, as these shorter maturities are especially sensitive to changes in expectations surrounding Federal Reserve policy and may become less appealing for basis strategies when investor demand for long positions diminishes.