As the so-called “basis trade” comes to an end, hedge funds appear to be reducing their historically large short positions in U.S. Treasury futures. Regulators have cautioned that this unwind could seriously jeopardise the integrity of the financial system.

With the Federal Reserve predicted to start lowering interest rates in 2019, maybe as early as March, focus will grow on the hedge fund industry’s profitable turnaround during the period when rates were increasing.

Hedge funds take advantage of the slight price differential between cash Treasuries and futures contracts in a relative value trade known as the basis trade.

They sell the bond future (going “short”) and purchase the cash bond (going “long”). The trade is heavily leveraged and funded in overnight repo markets.

If the unwind is in progress, the concern for regulators and the financial markets as a whole is how to unwind the $1 trillion position in a systematic way.

A “soft landing,” as it were.

This week, the Bank of England became the most recent financial institution to issue a warning regarding the potential for unwelcome market volatility if a big and highly leveraged position were to be quickly unwound.

“Sharp increases in volatility in market interest rates could lead to increases in margin required on the futures positions, or hedge funds may find it harder to refinance their borrowing in the repo market,” the BoE warned.

“This, combined with any breaches of risk- or loss-limits, could force funds rapidly to unwind their positions … which could amplify the market volatility,” it said.

However, an orderly unwind is feasible provided that there is no unanticipated liquidity shortage or market shock that compels the Fed to take emergency action, the overnight financing markets are quiet, and the requirements for funds’ margin aren’t abruptly increased.

The funds’ withdrawal from the basis trade ought to go more smoothly if the Fed’s rate-cutting strategy is more seamless this time around and the internal financial market infrastructure remains unobstructed.

“As long as we don’t have an event that would compel the Fed to cut rates by 50 or 100 basis points, I don’t think we will get a repetition of March 2020,” Christoph Schon, senior principal of applied research at Axioma, said.

The March 2020 ‘rush for cash’, when concerns about the Fed’s balance sheet, banking sector reserves, and the pandemic combined, is cited by the BoE and others, including the Fed and the Bank for International Settlements, as an example of where things can go wrong.

However, as shown in a July of that year Office of Financial Research document, there was no proof that funds pulling out of basis trades because of margin calls and volatility in repo rates contributed to the stress in Treasury markets at the time.

Schon highlights the beginning of the fund industry’s reduction of its record-high short position in Treasuries futures in the second half of 2019. While the stress in the repo market flared up late in the year, the unwind of hedge funds was, for the most part, pretty orderly.

When the epidemic struck in March of the following year, things only truly got out of control.

The total short position in Treasury futures owned by leveraged accounts—the hedge funds primarily involved in the basis trade—recently hit record highs, according to statistics from the Commodities Futures Trading Commission.

However, they are beginning to decline, especially around the short end of the curve.

Funds have reduced their gross short position in two-year futures for the past three weeks, and it appears that the record short position of 2.65 million contracts in the week ending November 7 will be the high.

The change has been even more significant in net terms; the record net short of 1.716 million contracts on November 7 has been reduced by more than 10%.

Leveraged funds reduced their short position by 95,000 contracts in the five-year space last week, marking one of the largest reductions in the recent three months.

In the first week of November, the record short aggregate position at a notional $1.008 trillion over two-, five-, and 10-year futures was reduced to $968 billion.

The “cash vs. futures” bond spread and arbitrage opportunities in the repo market, according to Oxford Economics’ director of global macro strategy Javier Corominas, have diminished the profitability of the basis trade.

“(This) suggests that financial stability risks emanating from forced selling of U.S. Treasuries in an adverse bond market scenario have diminished,” he wrote last month.

(Adapted from Reuters.com)

Categories: Economy & Finance, Entrepreneurship, Geopolitics, Regulations & Legal, Strategy