By Davide Barbuscia
NEW YORK (Reuters) – Federal Reserve researchers have warned in recent weeks of a potential fallout in U.S. Treasuries from the return of a popular hedge fund trading strategy that fueled a 2020 collapse in the world’s largest bond market.
Hedge funds’ short positions in some Treasury futures — contracts to buy and sell bonds for future delivery — have recently reached record highs as part of underlying transactions, giving the futures contracts more leverage than their prices. Underlying bonds, analysts said.
The trade—typically the relative value strategies of macro hedge funds—involves selling a futures contract, buying the underlying Treasuries with repurchase agreement (repo) funding, and delivering at the contract’s expiration.
In two separate notes in recent weeks, economists at the Fed have highlighted potential financial exposure risks associated with these trades, which are volatile in the US government bond market due to high interest rates and uncertainty over future monetary policy actions.
Fed economists said in an August 30 note that “money-forward basis positions may again be vulnerable to broader market corrections.” “Given these risks, trading orders are ongoing and diligently monitored.”
Separately, in a Sept. 8 note on, among other things, hedge funds’ exposure to Treasuries, Fed economists said there was a risk of a rapid reduction in core trading positions during periods of high funding.
This would exacerbate market stress, he warned, adding to “treasury market volatility and potentially exacerbating dislocations in the treasury, futures and equity markets.”
Commodity Futures Trading Commission (CFTC) data showed net shorts used in some Treasury futures were at their highest levels in recent weeks, tied to large asset managers’ long positions – an indicator of underlying trading.
“The Fed may not view this stockpile of basis positions in a very favorable light and may ultimately seek to clamp down on them,” said Steven Zheng, US rate strategist at Deutsche Bank. “However, the Fed does not have direct control over hedge funds, so their approach may not be straightforward,” he said.
The Fed declined to comment on possible policy measures.
Liquidity concerns
In March 2020, when the market was seized by the threat of the coronavirus pandemic, the disruption of fundamental transactions led to a panic in Treasuries, prompting the US central bank to buy $1.6 trillion of government bonds.
Some market players fear that a similar scenario could be in the cards again.
“Trades based on cash futures are exposed to two risks: high margin costs on short futures and high financing costs on long cash positions,” Barclays said in a note on Tuesday.
If financing costs rise in the repo market — where you get short-term loans against Treasuries and other securities — cash futures contracts should widen, or premiums on Treasuries should increase to make trading positions profitable.
Conversely, a sudden downturn in the economy and a rapid decline in interest rates can push futures higher, forcing a cap on large losses and exiting trades.
“This could lead to a repeat of the March 2020 market turmoil and is something the Fed is keen to prevent,” Deutsche’s Zeng said.
(Reporting by David Barbuccia; Editing by Megan Davis and Paul Simao)
