Key facts
- Hedge funds' leveraged positions in the Treasury basis trade have fallen 20% this year to $1.2 trillion.
- The Treasury basis trade involves borrowing overnight to profit from the narrow price difference between Treasury securities and futures.
- Demand for Treasury futures from asset managers has moderated, reducing the profitability of the basis trade.
- Hedge funds' net short positions in US 2-year Treasury futures have fallen by more than 40% from a 15-month high.
- Asset managers' net long positions in US 2-year Treasury futures have declined by more than 30% from an all-time high.
- New regulations adopted at the end of last year have made it easier for broker-dealer arms of banks to hold more Treasury inventory.
The Treasury basis trade, a strategy where hedge funds borrow overnight to profit from the narrow price difference between Treasury securities and their futures, has become less attractive this year. Funds involved in these leveraged trades have seen their positions decrease by 20% to $1.2 trillion, according to Morgan Stanley estimates. This pullback is attributed to a combination of factors, including a mostly uneventful rise in US interest-rate expectations and improved trading conditions, which tend to limit the trade's profitability.
The trade's appeal has been diminished by softer demand for both Treasury securities and futures. Additionally, higher Treasury inventories at large securities-dealing banks, a result of a rule change, and price increases for older bonds orchestrated by Treasury Secretary Scott Bessent have further compressed potential gains.
Meghan Swiber, US rates strategist at Bank of America, noted that the declining opportunity set and moderating demand for Treasury futures from asset managers have contributed to the reduction in basis positions. The basis trade is partly fueled by asset managers' demand for long-term Treasuries to increase the duration of their portfolios. Typically, hedge funds buy cash Treasuries and sell corresponding futures to asset managers, delivering the cheapest available security to settle the trade.
While the pullback has been most pronounced in futures tied to 2-year and 5-year maturities, which are more sensitive to rising Federal Reserve rate expectations, the overall activity in the basis trade remains significant. According to CFTC data, hedge funds' net short positions in US 2-year Treasury futures have fallen by over 40% from a 15-month high, and asset managers' net long positions have decreased by over 30% from an all-time high in March.
Despite the reduced activity, experts and portfolio managers interviewed by Reuters indicated that hedge funds still hold substantial positions in the basis trade. The New York Federal Reserve has reportedly raised questions about potential systemic risks associated with these large leveraged Treasury holdings. A 2024 paper by Steven T. Williams suggested that market shocks could occur if rates were to reverse suddenly, due to an imbalance stemming from a duration shortfall for mortgage-backed securities held by asset managers, who are significant buyers of Treasury futures.
Morgan Stanley analysts, however, believe the trade remains active, stating, "While returns have become less attractive and notional has declined, we think the trade remains alive and well." New regulations adopted late last year have eased restrictions on broker-dealer arms of banks, allowing them to hold more Treasury inventory, which some experts suggest has increased liquidity. This loosening of supplementary leverage ratio (SLR) requirements has reduced the relative value opportunity for basis traders, as dealers' increased capacity to hold inventory, hedged in the futures market, narrows the price discrepancies they typically exploit.