Back to 2019
The hedge fund community appears to have returned as the marginal buyer of cash Treasuries through a resurgence of the cash futures basis trade. The recent surge in Treasury repo volumes and record short Treasury futures positioning by hedge funds strongly suggest a revival of the trade, which was popular prior to 2020. This would indicate steady demand for cash Treasuries even as the Fed and commercial banks moved from large net buyers to net sellers. While the cash futures basis trade is itself not directional, a widening basis may indicate that the real money investment community is seeking to increase duration exposure through futures. This post reviews the mechanics of the trade, walks through evidence of its resurgence, and suggests it reflects positioning for lower inflation.
Treasury Cash-Futures Basis
The Treasury cash-futures basis trade aims to profit from dislocations between the pricing of Treasury futures and cash Treasuries. At times, asset managers like pension funds have chosen to gain exposure to Treasuries through futures. That increased demand raises the price of Treasury futures relative to cash Treasuries such that it is possible to make a small profit by selling short a Treasury future and hedging it with a cash Treasury. The price of the Treasury future and cash Treasury eventually converge so the investor makes a small profit. While the price dislocation is small, unconstrained investors like hedge funds can put on the trade with significant leverage from repo borrowing to magnify returns.
The cash-futures basis trade was very popular in 2019 and thought to account for the significant rise in hedge fund Treasury exposure. According to confidential data, hedge funds increased their long cash Treasury and short Treasury futures by several hundred billion from 2018 to 2020. The same period also saw a steady rise in repo volumes. In effect, the hedge fund community was the marginal investor in cash Treasuries prior to 2020. The trade became much less popular after the significant market dislocations in March 2020.
Repo volumes and COT positioning suggest that the cash futures basis trade has returned in size. SOFR volumes, a measure of overnight Treasury repo volumes, has soared to multi-year highs. SOFR largely reflects the financing activity of dealers, who can then turn around and re-lend the funds to hedge funds in bilateral repo. Dealers can also borrow to finance their own inventory of securities, but public data indicate modest increases in holdings relative the rise in financing volumes.
The CFTC’s weekly COT data indicate that hedge funds have steadily built significant short positions in Treasury futures since last July, which was also when repo volumes began to climb. Together this suggests a resurgence of the cash-futures basis trade to levels that that exceed their 2019 peak. Also note that the rising short positions are mirrored by the long positions by the real money investors like pension funds, who operate under more stringent investment constraints.
Heightened official sector interest on the potential dangers of the cash futures basis trade also appear to confirm its resurgence. The turmoil in the March 2020 Treasury market was in part due to rapid deleveraging by cash futures basis traders. However, the trade is also an important provider of liquidity in the cash market. Increasing regulatory costs on the trade would likely structurally widen the basis, much like the persistence of negative swap spreads and the widening FX swap basis since the implementation of Basel III.
Increasing Duration Exposure
The widening basis may indicate that the real money investment community is looking for directional exposure to duration. Treasury futures are capital efficient and very liquid, so they are ideal instruments for tactical allocations. However, it is impossible to say definitively without looking at an asset manager’s entire portfolio. The increase in Treasury futures exposure could simply be a replacement for cash bonds or a reflect a change in an asset manager’s liability structure. But the steady increase in positioning also coincides with persistent downside risk priced into short rate futures and widely perceived recessionary sentiment. If it is a tactical allocation, then that suggests the pain trade for yields is higher.
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