US Treasury basis trade shrinks to its smallest size in over two years

US Treasury basis trade shrinks to its smallest size in over two years

Hedge funds have unwound hundreds of billions in leveraged positions as the once-lucrative strategy runs out of room

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By Editorial Team
Edited by Estefano Gomez

A popular Treasury hedge fund trade has shrunk to its smallest size in more than two years as narrowing price gaps leave fewer arbitrage opportunities for investors.

Morgan Stanley estimates leveraged investors now hold about $900 billion in Treasury basis trades, down from $1.26 trillion at the start of the year. The strategy typically involves buying Treasury bonds while selling related futures and using substantial leverage to profit from small pricing differences.

The decline has been concentrated in contracts tied to two year and five year Treasuries, where the price difference between futures and underlying bonds has narrowed. Longer maturity basis positions remain more active, according to Morgan Stanley.

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Strategists said the pullback does not currently indicate stress in the Treasury market. Citi rates strategist Jason Williams said smaller positions reflect fewer dislocations and lower volatility, potentially signaling stronger underlying demand for Treasuries.

One factor has been weaker demand from asset managers for shorter maturity Treasury futures. As futures demand falls, the premium over underlying bonds narrows, reducing the potential return available to hedge funds running the basis trade.

Other changes have also reduced arbitrage opportunities. The Treasury has expanded purchases of older securities through its buyback program, including doubling the maximum size of some longer maturity liquidity operations to at least $4 billion.

The Federal Reserve has also stopped allowing its Treasury holdings to run off, instead rolling over principal payments and maintaining an ample level of reserves. The shift has helped support liquidity across short term funding markets used by leveraged Treasury traders.

The basis trade has previously attracted regulatory scrutiny because heavy leverage can amplify market stress if hedge funds rapidly unwind positions. A sharp reversal contributed to Treasury market disruptions in March 2020 before the Federal Reserve intervened.

For now, strategists see little evidence of a similar risk. Morgan Stanley said current funding conditions remain resilient, while the decline in basis positions appears driven primarily by weaker relative value opportunities rather than forced deleveraging.

Disclosure: This article was edited by Editorial Team. For more information on how we create and review content, see our Editorial Policy.
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US Treasury basis trade shrinks to its smallest size in over two years
US Treasury basis trade shrinks to its smallest size in over two years

Hedge funds have unwound hundreds of billions in leveraged positions as the once-lucrative strategy runs out of room

By Editorial Team
Edited by Estefano Gomez

Share

Add us on Google

A popular Treasury hedge fund trade has shrunk to its smallest size in more than two years as narrowing price gaps leave fewer arbitrage opportunities for investors.

Morgan Stanley estimates leveraged investors now hold about $900 billion in Treasury basis trades, down from $1.26 trillion at the start of the year. The strategy typically involves buying Treasury bonds while selling related futures and using substantial leverage to profit from small pricing differences.

The decline has been concentrated in contracts tied to two year and five year Treasuries, where the price difference between futures and underlying bonds has narrowed. Longer maturity basis positions remain more active, according to Morgan Stanley.

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Strategists said the pullback does not currently indicate stress in the Treasury market. Citi rates strategist Jason Williams said smaller positions reflect fewer dislocations and lower volatility, potentially signaling stronger underlying demand for Treasuries.

One factor has been weaker demand from asset managers for shorter maturity Treasury futures. As futures demand falls, the premium over underlying bonds narrows, reducing the potential return available to hedge funds running the basis trade.

Other changes have also reduced arbitrage opportunities. The Treasury has expanded purchases of older securities through its buyback program, including doubling the maximum size of some longer maturity liquidity operations to at least $4 billion.

The Federal Reserve has also stopped allowing its Treasury holdings to run off, instead rolling over principal payments and maintaining an ample level of reserves. The shift has helped support liquidity across short term funding markets used by leveraged Treasury traders.

The basis trade has previously attracted regulatory scrutiny because heavy leverage can amplify market stress if hedge funds rapidly unwind positions. A sharp reversal contributed to Treasury market disruptions in March 2020 before the Federal Reserve intervened.

For now, strategists see little evidence of a similar risk. Morgan Stanley said current funding conditions remain resilient, while the decline in basis positions appears driven primarily by weaker relative value opportunities rather than forced deleveraging.

Disclosure: This article was edited by Editorial Team. For more information on how we create and review content, see our Editorial Policy.