Back to 2019

Published on May 30, 2023 by Free

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.

Hedge funds significantly increased their cash Treasury positions and short Treasury futures positions, which together suggests a cash-futures basis trade.

It’s Back

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.

Overnight Treasury Repo Volumes surges to multi-year highs.

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.

[Note from Joseph: Thank you for following my work these years – I am grateful for your readership. My goal has been to provide institutional level expertise to a broader audience. I hope that you have found it helpful and interesting. Please note that I have decided to make this into a subscription service in the near future.]

19 comments On Back to 2019

  • That’s funny. I’ve always thought subscription services were for advisors who couldn’t make enough money on their own accounts. I used to say I didn’t need a disclaimer.

  • Note: I did buy your book.

  • There will be large issuance by the Treasury after lifting the Debt Ceiling, leading to even higher rates and downside to Treasury futures on the short end.

  • Charges on all debt, public and private sectors, are related to a cumulative figures; and since the multiplier effects of debt expansion on income, the ingredient from which the charges must inevitably be paid, is a non-cumulative figure, it is inevitably that a mathematical time will arrive when further debt expansion is no longer a practical or possible expedient, either to provide full employment or to keep debt charges with tolerable limits.

  • Implied repo rate on Tsy futures appears to be less than SOFR – so if anything it feels like HFs would be going other way on basis trade (buying futures and shorting cash bonds)?

    • Good point. I think that means the trade is not attractive today, but it seems most of the trades were put on the past several months. I imagine the implied financing for ctd would be much higher today without a few hundred billion already deployed.

    • IRRs on Tsy futures are most definitely higher than the SOFR swap out to delivery except for US and WN. HFs are not short the basis, they are long.

  • Long cash treasury, short treasury future looks like free profit to me. Who will take the other side of the bet that is a mostly a losing position.

  • Good piece. Bummed to see you’re going paid.

  • Hello Joseph, thanks for the insightful piece. One question please: once the debt ceiling charade is resolved, Yellen will have to fill up the TGA either by issuing t-bonds or, as some pundits argue, by trying to divert some of those $2T sitting at the RRP into short term t-bills. If she chose the latter… what would be the actual mechanics to make it happen?

    • The FED would just have to adjust the O/N RRP award rate.

      Contrary to Powell, never are the commercial banks intermediaries, conduits between savers and borrowers, in the savings->investment process. Money and credit creation is a system-wide process. The necessity of Covid-19’s Treasury’s debt-support operations should have been foreseen, and thereby offset, by raising reserve ratios – not by eliminating them.

      As Dr. Milton Friedman pontificated in a letter to Dr. Leland Pritchard (his classmate in Chicago): From Carol A. Ledenham’s Hoover Institution archives: “I would make reserve requirements the same for time and demand deposits”. Dec. 16, 1959.

  • Another really great read. Old man from rural Maine.

  • These articles should have dates in the title or somewhere

  • Can you please add dates to your posts? Preferably at the top…

  • You should have added Basis chart and how it moves to make it clear

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