The Treasury basis trade rears its head again

Yesterday our MainFT colleagues published an important story about some of the US government bond market’s weird behaviour lately, which, unfortunately, quickly got buried by the unending avalanche of other news.

Fortunately, it also helps explain why US Treasuries have gotten hit hard again today, despite the stock market dipping back down again on more bad tariff headlines. From Monday’s story, with Alphaville’s emphasis below:

US government debt sold off sharply on Monday as hedge funds cut back on risk in their strategies and investors continued shifting into cash during a third day of acute tumult on Wall Street.

The benchmark 10-year Treasury yield jumped 0.19 percentage points on Monday to 4.18 per cent, the biggest daily rise since September 2022, according to Bloomberg data. The 30-year yield jumped 0.21 percentage points, the biggest move since March 2020.

. . . Investors and analysts pointed in particular to hedge funds that took advantage of small differences in the price of Treasuries and associated futures contracts, known as the “basis trade”. These funds, which are large players in the fixed-income market, unwound those positions as they cut back on risk, prompting selling in Treasuries.

“Hedge funds have been liquidating US Treasury basis trades furiously,” said one hedge fund manager.

The sell-off has now continued into Tuesday, with the 10-year Treasury yield climbing 4.29 per cent at pixel time. That’s a pretty chunky move of 13 basis points on the day, and the 10-year yield has now see-sawed up 42 bps since its low on April 4. That’s pretty noticeable, given that “risk-off” remains the dominant sentiment.

As Bespoke Investment Group’s George Pearkes wrote in a report today:

While the historic reversal in stocks today that saw the market close near the lows down over 1.5% having been up more than 4% at the highs is concerning, the rumblings in fixed income feel far more problematic. Over the last two days, 30y UST yields have risen a brutal 35 bps. While that’s not an all-time superlative, it’s extremely unusual, in the top 0.4% of all 2-day moves for the long bond yield.

What’s much more unusual is the fact that this large surge in bond yields has come with stocks dropping. In fact, this is the largest two-day increase in 30y yields with stocks down at least 1.5% over the same span since 1982!

It’s always hard to disentangle market drivers, and there are probably multiple culprits behind the Treasury sell-off, such as a weak auction of three-year notes and the Treasury swap spread trade unwinding. But the Treasury basis trade appears to be a big factor behind the cracks in the US government bond market.

As many Alphaville readers will know, we are above-average interested in the Treasury basis trade, and have been ever since it scared the bejesus out of us back in March 2020. For the uninitiated, here’s a quick explainer of what the Treasury basis trade is, and why it’s potentially problematic.

Treasury futures contracts typically trade at a premium to the government bond you can deliver to satisfy the derivatives contract. That’s mostly because they are a convenient way for investors to gain leveraged exposure to Treasuries (you only have to put down an initial margin for the nominal exposure you’re buying). Asset managers are as a result mostly net long Treasury futures.

However this premium opens up an opportunity for hedge funds to take the other side. They sell Treasury futures and buy Treasury bonds to hedge themselves, capturing an almost risk-free spread of a few basis points. Normally, hedge fund managers don’t get out of bed for a few measly bps, but because Treasuries are so solid you can leverage the trade many, many times.

Let’s say you put down $10mn for Treasuries and sell an equal value of futures. You can then use the Treasuries as collateral for, say, $9.9mn of short-term loans in the repo market. Then you buy another $9.9mn of Treasuries, sell an equivalent amount of Treasury futures, and the repeat the process again and again and again.

It’s hard to get firm idea of what is the typical amount of leverage that hedge funds use for Treasury basis trades, but Alphaville gathers that as much as 50 times is normal and up to 100 times can happen. In other words, just $10mn of capital can support as much as $1bn of Treasury purchases.

And how significant is the trade in aggregate? Well, it’s an imperfect measure for a lot of reasons, but the best proxy for its overall size is the net short Treasury futures positioning of hedge funds, which currently stands beyond $800bn, with asset managers the mirror image on the long side.

The problem is that both Treasury futures and repo markets demand much more collateral when there is an unusual amount of volatility in the Treasury market. And if the hedge fund can’t pony up then lenders can seize the collateral — Treasury bonds — and sell them into the market.

As a result, it is a major danger lurking inside the market that is supposed to be the financial system’s equivalent of a bomb shelter, as Apollo’s Torsten Sløk pointed out earlier today:

Why is this a problem? Because the cash-futures basis trade is a potential source of instability. In case of an exogenous shock, the highly leveraged long positions in cash Treasury securities by hedge funds are at risk of being rapidly unwound. Such an unwind would have to be absorbed, in the short run, by a broker-dealer that itself is capital-constrained. This could lead to a significant disruption in market functions of broker-dealer firms, such as providing liquidity to the secondary market for Treasuries and intermediating the market for repo borrowing and lending.

We saw exactly how this latent vulnerability can morph into a systemic risk in March 2020, when a “dash for cash” by foreign central banks and bond funds swamped by investor withdrawals were forced to ditch the most sellable asset they had: US Treasuries. That in turn pummelled hedge funds that had put on monstrously leveraged Treasury basis trades, and threatened to turn a messy bout of Treasury liquidation into a cataclysmic financial crisis.

Only Herculean efforts by the Federal Reserve — its balance sheet expanded by $1.6tn in just one month — prevented it.

What happened late on Friday and on Monday is nothing near what we saw in March 2020, when for over a week the US Treasury market — the bedrock for the entire global financial system — came close to breaking. But as our colleagues pointed out, the volatility has been high, and that they sold off so violently yesterday is highly suggestive of at least some levered Treasury trades getting forcibly liquidated:

Column chart of Daily change (percentage points) showing US 10-year Treasuries sell-off

Many regulators and policymakers have been worried about the Treasury basis trade ever since, not least because the Fed’s actions constituted a de facto bailout of the strategy. That the basis trade has since swelled to become far larger than it ever was before March 2020 has understandably increased those concerns even further.

Unfortunately, doing something forceful about it is difficult precisely because the basis trade has become such a major pillar of support for the Treasury market, at a time when the US government’s borrowing costs have already ballooned.

As Citadel’s Ken Griffin noted back in 2023 — when the SEC’s then-head Gary Gensler had the strategy in his crosshairs — killing Treasury basis trade would “increase the cost of issuing new debt, which will be borne by US taxpayers to the tune of billions or tens of billions of dollars a year”.

So far it doesn’t seem like any basis trade liquidation is having a major disruptive effect on the Treasury market. What was scary in 2020 was both how yields moved up when they should be moving down, and how trading gummed up completely in an asset class that nowadays often sees about $1tn of trading a day.

That doesn’t seem to happened so far, even if Treasury yields moving higher on risk-off days like today is a little disconcerting. However, Bloomberg’s index of Treasury market liquidity (caveats!) has been a little loopy lately, so this is one to keep an eye on.