Researchers at the Federal Reserve have issued warnings in recent weeks about possible disruptions in U.S. Treasuries because of the return of a popular hedge-fund trading strategy that exacerbated a crash in the world’s biggest bond market in 2020.
Hedge funds’ short positions in some Treasuries futures – contracts for the purchase and sale of bonds for future delivery – have recently hit record highs as part of so-called basis trades, which take advantage of the premium of futures contracts over the price of the underlying bonds, analysts have said.
The trades – typically the domain of macro hedge funds with relative value strategies – consist of selling a futures contract, buying Treasuries deliverable into that contract with repurchase agreement (repo) funding, and delivering them at contract expiry.
In two separate notes in recent weeks, economists at the Fed have highlighted potential financial vulnerability risks related to these trades, which are taking place at a time of volatility in the U.S. government bond market because of higher interest rates and uncertainty over future monetary-policy actions.
“Cash-futures basis positions could again be exposed to stress during broader market corrections,” Fed economists said in an Aug. 30 note. “With these risks in mind, the trade warrants continued and diligent monitoring.”
Separately, in a Sept. 8 note that looked at, among other things, hedge funds’ Treasury exposures, Fed economists said there was a risk of a rapid unwind of basis trade positions in case of higher repo funding costs.
This would exacerbate episodes of market stress, they warned, “potentially contributing to increased Treasury market volatility and amplifying dislocations in the Treasury, futures, and repo markets.”
Commodity Futures Trading Commission (CFTC) data showed leveraged funds’ net shorts on some Treasuries futures were at near record highs in recent weeks, matched by large asset managers’ long positions – an indication of basis trades.
“The Fed is unlikely to view this accumulation of basis positions under too favourable a light and may eventually want to clamp down on them,” said Steven Zeng, U.S. rates strategist at Deutsche Bank. “However, the approach they take may not be straightforward as the Fed does not have direct regulatory oversight over hedge funds,” he said.
The Fed declined to comment on possible policy actions.
LIQUIDITY CONCERNS
The unwinding of basis trades contributed to illiquidity in Treasuries in March, 2020, when the market seized up amid rising fears about the coronavirus pandemic, prompting the U.S. central bank to buy US$1.6-trillion of government bonds.
Some market players fear a repeat or a similar situation may still be in the cards.
“Cash futures basis trades are vulnerable to two risks: higher margin costs on the futures short and higher financing costs on the cash long position,” Barclays said in a note on Tuesday.
Should financing costs increase in the repo market – where hedge funds obtain short-term loans against Treasury and other securities – the spread, or premium, of futures contracts over underlying cash Treasuries would also need to increase to keep basis trade positions profitable.
Conversely, a sudden deterioration in the economy and a rapid drop in interest rates could push futures higher, triggering limits on maximum losses and forcing basis trade exits.
“This could potentially bring about a repeat of the March, 2020, market turmoil and it is something that the Fed is keen to prevent,” Deutsche’s Mr. Zeng said.
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