Hedge funds are starting to pull back from the Treasury basis trade, a strategy that exploits small price differences between Treasury bond futures and the underlying cash bonds. This reduction in activity is occurring because the gaps that these funds wager on are narrowing, diminishing the appeal of the trade which relies heavily on borrowed cash to amplify modest returns. Some market participants, like Chris Horvatin, a managing director at Goldman Sachs, have even described the trade as effectively "dead" due to the lack of attractive spreads.
This slowdown follows a period where the basis trade had significantly grown. According to a Federal Reserve economist, the trade accounted for $830 billion of hedge funds' Treasury long positioning as of September, double its previous peak in early 2020 and representing 35% of their total long Treasury exposure. However, Morgan Stanley estimates that the capital tied up in these positions has recently fallen by over $200 billion to approximately $1 trillion, indicating a decline in its expansion.
Several factors are contributing to the reduced attractiveness of the basis trade. US banks have increased their Treasury holdings and are hedging interest-rate risk by shorting Treasury futures, which compresses the spreads basis traders seek. This shift is partly due to changes in bank capital rules, including a relaxation of the enhanced supplementary leverage ratio. Additionally, asset managers have reduced their long positions in shorter-dated Treasury futures, leading to weaker demand for futures and a reduction in the premium over cash bonds that typically creates basis-trade opportunities. Changes in expectations for US monetary policy, particularly following the Iran-US conflict, with traders moving away from anticipated rate cuts to positioning for potentially higher rates, also play a role.
Other market developments are also limiting dislocations for hedge funds. The US Treasury's borrowing mix has shifted towards short-term bills, and the Federal Reserve has stopped shrinking its balance sheet, altering the supply and liquidity dynamics in the Treasury market. Evidence of reduced activity is also visible in funding markets used to support leveraged basis positions, and hedge funds' net short positions in Treasury futures have declined. Major participants in this strategy have traditionally included macro hedge funds and multi-strategy firms such as Millennium Management, ExodusPoint Capital Management, Citadel, and Capula Investment Management.
The potential for a sustained reduction in basis-trade activity could have broader implications for the $32 trillion Treasury market, which has increasingly relied on hedge funds for liquidity and to absorb risk. The strategy came under scrutiny after rapid unwinding during the market turmoil of March 2020, prompting regulators to warn about the risks of highly leveraged trades concentrated among a small group of participants. While the current slowdown does not necessarily signal an imminent disorderly unwind, the basis could regain attractiveness if economic conditions shift, such as a renewed consensus around interest-rate cuts that boosts demand for Treasury futures. This decline in hedge fund activity coincides with the US Treasury's unusual intervention of increasing buybacks of its own longer-dated bonds, aiming to lower borrowing costs amid plunging bond prices and surging yields.
