Market Data 
By Jamie McGeever
ORLANDO, Florida (Reuters) – Leverage in the U.S. Treasury market is picking up again, counterintuitively feeding off a “higher-for-longer” interest rate environment and building up potential trouble in the event of a price or rate shock.
After gradually but steadily scaling back exposure earlier this year, asset managers and leveraged funds are now rebuilding their respective long and short positions in Treasury futures contracts at a rapid clip.
There is a lot of anxiety swirling around the U.S. bond market just now – much of it justified – with inflation proving sticky, and the prospect of huge deficits for years to come calling into question the depth and strength of investor demand.
But the longer interest rates are kept on hold, the more attractive it is for futures market participants – asset managers are drawn in by higher yields, and higher yields make the ‘basis trade’ more appealing for leveraged funds on the short side.
Data shows that asset managers’ aggregate long position, spear-headed by mutual fund buying, has rocketed to a new record and leveraged funds’ short position is also expanding, bringing the basis trade back into focus.
The basis trade involves leveraged hedge funds arbitraging the small price difference between cash Treasuries and futures, a trade funded via the overnight repo market. Regulators have warned of major financial stability risks if these funds, some levered up to 70x, are forced to quickly cover their positions.
DISPROPORTIONATE
Commodity Futures Trading Commission data for the week to April 30 show that asset managers’ aggregate long position in two-, five- and 10-year Treasury futures rose to 8.15 million contracts, worth a record $1.045 trillion. That’s up 12% on last year’s high.
The shift at the short end has been even greater. Asset managers’ long position in two-year futures is now worth $458 billion – a new record, up 17% from last year’s peak, and remarkably, up more than a third in the last month.
These figures coincide with a new 82-page paper ‘Reaching for Duration and Leverage in the Treasury Market’ by Federal Reserve economists, a deep-dive analysis of positioning data in Treasuries futures.
The paper doesn’t cover developments in the last few weeks but does shed light on the broader trend, which shows the rise in asset manager longs in Treasury futures fueled by “disproportionately large positions” held by mutual funds, especially in shorter-dated contracts.
“In managing their dual objectives of generating returns for investors while matching a benchmark index duration, mutual funds’ reach-for-duration incentive drives greater leverage in the Treasury market,” the authors wrote.
“An indirect consequence of mutual funds’ demand for futures positions is the associated Treasury market leverage introduced through hedge funds. Both of these sources of leverage may present increased risks to Treasury markets, as materialized during March 2020,” they added.
MILKING IT
In early 2020 a disorderly unwind of hedge funds’ short positions triggered severe volatility and illiquidity in the Treasury market. The Bank for International Settlements and Bank of England, among others, have warned that leveraged funds’ large short position risks a repeat.
The latest CFTC figures show leveraged funds’ aggregate short position at a two-month high of $858 billion, below the $1 trillion peak from November but higher than when the BoE and BIS were sounding the warning bell last year.
Christoph Schon, senior principal of applied research at Axioma, says the rise in mutual funds’ long Treasury futures position should not be a surprise – yields are more attractive now and bonds are competing with equities for the first time in a long time.
On the flip side, hedge funds are rebuilding their short positions because interest rates have been kept ‘higher for longer’ and rate cut expectations have been slashed, meaning they can “milk the basis trade a little bit longer.”
“The basis trade only becomes an issue if interest rates change suddenly, like 100 basis points in two weeks. But if we get four successive cuts of 25 bps over several months, there won’t be a repeat of March 2020,” Schon said.
(The opinions expressed here are those of the author, a columnist for Reuters.)
(By Jamie McGeever; Editing by Andrea Ricci)
