Hedge funds have significantly increased their involvement in the US Treasury market, with positions in cash bonds and derivatives totaling $4.04 billion as of September last year, a nearly 40% increase from $2.89 billion in December 2023. These funds typically utilize a highly leveraged strategy known as the "basis trade," where they buy cash Treasuries and simultaneously sell futures contracts on the same bonds, profiting from small price discrepancies. This trade often involves leveraging their own capital by 50 to 100 times, borrowing heavily from large dealer banks through repurchase agreements (repos).
The allure of long-dated Treasuries, traditionally favored by large, long-term investors, has diminished. The share held by long-term Treasury investors, including primary dealers, overseas central banks, and pension funds, has fallen to 52% this year from 75% in 2007. This vacuum is being filled by hedge funds with a short-term trading focus. However, this reliance on short-term funding and high leverage introduces significant risk. If bond prices fall, hedge funds are required to post additional collateral to their lenders. If they cannot, they may be forced to sell their bond positions, potentially triggering a sharp drop in prices and a surge in yields.
Warning signs are escalating in the Treasury market. The 30-year Treasury yield is now 0.5 percentage points above the 10-year yield, an increase from a 0.2 percentage point gap at the start of 2025. This indicates a weakening appeal for long-dated Treasuries. Furthermore, the shrinking role of primary dealers, whose share of Treasury purchases has dropped from 40-50% in 2010 to 10-15% this year, exacerbates market fragility. The total sovereign debt has swelled to $31 trillion from $4.5 trillion since 2007, with annual interest costs exceeding $1 trillion. The US government is projected to issue $1.8 trillion to $2 trillion in Treasuries this year to cover its deficit. These market dynamics, coupled with the highly leveraged positions of hedge funds, raise concerns that even a small shock could lead to significant turmoil in the Treasury market, especially if banks reduce lending.
