The most crowded trade in fixed income appears to be running out of room. Hedge funds that have piled into the Treasury bond basis trade, a leveraged strategy that has quietly become one of Wall Street’s favorite money machines, are finding that the party might be winding down.

Morgan Stanley estimates that leveraged positions in the trade have declined by more than $200 billion, bringing the total down to roughly $1 trillion.

What the basis trade actually is

Here’s the setup. Hedge funds buy actual Treasury bonds in the cash market while simultaneously shorting Treasury futures contracts. The goal is to capture the tiny price gap between the two. The spread between cash bonds and futures is usually razor-thin. We’re talking basis points. So to make the math work, funds crank up leverage, sometimes 50x or more, turning a whisper of profit into a shout.

Eli Carter, a US rates strategist at Morgan Stanley, pointed to the stagnation in expansion as evidence that the strategy may have reached its maximum capacity.

Why the trade is stalling

With roughly $1 trillion still deployed in basis trade positions, this isn’t a collapse story. It’s a saturation story. The easy gains have been extracted, and the marginal return on adding new positions has dropped to the point where even leverage-happy hedge funds are pausing.

We’ve seen this movie before. In 2020, the basis trade unwound violently during the early COVID panic, forcing the Federal Reserve to step in with massive Treasury purchases to stabilize the market. The trade has since rebuilt itself to even larger levels.