Hedge funds pare back US Treasury basis trades

Hedge funds are reducing exposure to US Treasury basis trades, with Morgan Stanley estimating capital deployed in leveraged positions has fallen roughly 20% to $1.2 trillion so far this year. The pullback comes as returns have weakened and demand for both cash Treasuries and related futures has eased.

The basis trade involves buying cash Treasury securities and shorting the corresponding futures contracts. Funds typically finance the cash positions with short-term borrowing and use leverage to try to capture small price differences between the cash bond and the futures delivery basket.

Market conditions this year have narrowed some of the price gaps that basis traders look to exploit. Treasury prices have been under pressure as buyer interest in cash securities and futures softened. At the same time, major securities dealers are holding larger Treasury inventories after regulatory changes, and government buybacks have supported prices for older, off-the-run securities. Those dynamics have reduced discrepancies between eligible cash bonds and futures delivery baskets.

The decline in basis activity has been strongest in futures linked to the two- and five-year parts of the curve. Positions in those maturities are especially sensitive to shifts in expectations for Federal Reserve policy, and rising rate expectations that moved in a relatively orderly way have left smaller spreads for arbitrage.

The strategy uses substantial borrowing and has been scrutinized in past periods of market stress. When leveraged positions move against traders, margin calls can force rapid selling of Treasuries, which can amplify declines if liquidity is thin. Market participants report the current retreat reflects a less favourable opportunity set rather than a disorderly unwind of positions.

Basis trading remains active across the curve, including benchmark 10-year and longer maturities, and funds often act to facilitate duration needs for mutual funds and other asset managers by buying cash bonds and selling futures. Bonds purchased for these trades can later be delivered against futures contracts, typically using the cheapest eligible security for settlement.

The reduction in activity has removed a source of leverage that previously helped arbitrage small price differences between cash and futures. Morgan Stanley’s estimate that deployed capital has fallen to about $1.2 trillion provides a measure of the scale of the pullback. Factors that will shape future activity include dealer inventories, government buybacks and expectations for US interest rates.