Hedge funds’ leveraged trade in Treasury market is drawing scrutiny


Hedge funds’ increased use of leveraged trades in the $25.1 trillion Treasury market is now drawing scrutiny from economists at the Federal Reserve Board in Washington.

In a paper, economists Daniel Barth and R. Jay Kahn, both with the Fed board, and Robert Mann of the U.S. Treasury Department said that so-called basis trades by hedge funds warrant “continued and diligent monitoring,” and that sustained large exposures by hedge funds would “present a financial stability vulnerability.”

“Is the basis trade ‘back’? In short, the answer is ‘probably,’ at least to some degree,” they wrote in the paper posted to the Fed’s website. Data from the Commodities Futures and Trading Commission, along with the Treasury Department’s Office of Financial Research, are consistent with hedge funds increasing their positions in the basis trade, according to the economists.

Source: Office of Financial Research’s Cleared Repo Collection, Commodities Futures and Trading Commission’s Traders in Financial Futures data.

The basis trade uses leverage to arbitrage the price differences between Treasury futures and cash Treasurys. It involves “a short Treasury futures position, a long Treasury cash position, and borrowing in the repo market to finance the trade and provide leverage,” Barth, Kahn and Mann wrote.

Such a trade is seen as one of the biggest ways in which hedge funds have ramped up an overall bearish view on U.S. government debt — diverging from asset managers and individual investors in a way that’s led to a zigzagging 10-year yield BX:TMUBMUSD10Y in August.

Read: Asset managers and hedge funds are increasingly taking different positions in the U.S. Treasury market

“This trade presents a financial stability vulnerability because the trade is generally highly leveraged and is exposed to both changes in futures margins and changes in repo spreads,” Barth, Kahn and Mann wrote. For example, “hedge funds unwinding the cash-futures basis trade likely contributed to the March 2020 Treasury market instability.”

Cash-futures basis positions “could again be exposed to stress during broader market corrections. With these risks in mind, the trade warrants continued and diligent monitoring.”

As of Thursday afternoon, 1- BX:TMUBMUSD01Y through 30-year Treasury yields BX:TMUBMUSD30Y were little changed to slightly lower ahead of Friday’s nonfarm payrolls report for August.

This article was originally published by Marketwatch.com. Read the original article here.

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