Beware a Sudden Shift in Treasury Yield Curve

(Bloomberg) — Investors around the world have a warning for hedge funds embracing a popular, highly leveraged Treasuries trade: beware a sudden shift in the yield curve.

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With short-term US borrowing costs now topping their long-term equivalents by one percentage point, the yield curve is already heading for one of its longest and deepest inversions. A sharp reversal would threaten to upend the strategy, known as basis trade.

The strategy, which seeks to exploit the pricing difference between cash bonds and futures, has been gaining in popularity this year after imploding spectacularly at the height of the pandemic in 2020. If the yield curve were to suddenly steepen, either because long-term yields rise or short-term rates slump, it would be enough to send traders scurrying to close the bets.

The basis trade “is a bit like picking up pennies in front of a steamroller,” said James Novotny, money manager at Jupiter Asset Management in London. “It works when volatility is kind of low or falling,” however “given the extreme nature of the rate prices in the US there is obviously a potential for volatility to be up there and that would certainly create issues.”

Recent Treasuries positioning suggests that leveraged traders have kept adding to their basis trade bets, in part facilitated by asset managers who’ve piled into the other side of the wager to hedge interest-rate exposure. A recent JPMorgan Chase & Co. survey of Treasury clients shows that cohort have built their largest net long position since 2010.

The extreme positioning raises the stakes for traders who have taken advantage of a drop in volatility to reboot the basis.

Hedge funds plying the trade borrow heavily in the repurchase market and use that leverage to exploit the price gap between Treasury futures and underlying cash bonds. The basis trade backfired spectacularly in March 2020 when the pandemic triggered a stampede into US bond futures, that played a key role in Federal Reserve intervention to the tune of over $5 trillion to restore calm.

Such bets aren’t confined to Treasuries. Pockets of Japan’s bond market also came under pressure last June after the nation’s central bank tweaked its debt purchase plans, triggering a blowout in spreads between futures and underlying cash bonds to levels last seen nearly a decade ago.

Now investors are turning to the next potential catalyst that may crush the trade: rapid and seismic shifts in US rate wagers that stand to upend yield curves everywhere.

“Hedge funds in particular have been selling Treasury futures to express that view that there were too many cuts priced in,” said Andres Sanchez Balcazar, head of global bonds at Pictet Asset Management SA which oversees $680 billion. Investors worry about “squeezes in liquidity” should the trades go awry, he added.

Speculation is building that the Treasuries curve may steepen after its inversion deepened to over one percentage point last week as short-end yields climbed following Fed Chair Jerome Powell’s testimony to Congress. On Wednesday in Sintra, Portugal, Powell left the door open to the Fed increasing borrowing costs at two consecutive meetings after it took a break from tightening this month.

His recent remarks have gone some way to damping hopes for an easing but data from the Commodity Futures Trading Commission show that hedge funds have not completely abandoned wagers for a policy pivot in the near term.

It’s “definitely possible” that a big adjustment in US rate bets may trigger volatility that capsizes the basis trade, said Hideo Shimomura, senior portfolio manager at Fivestar Asset Management Co. in Tokyo. “When inverted yields correct, with a gain in longer-term yields, those positions may be liquidated.”

‘Explosive Move’

The prospect of an upheaval in the Treasuries market is fueling jitters far beyond US shores.

Crowded positioning, including in basis trades, “just builds up the momentum or builds up the energy for an explosive move on either side,” said Leonard Kwan, a money manager at T. Rowe Price Group Inc. in Hong Kong, which oversees $1.35 trillion. “When basis blows up or moves significantly, one way or the other, it’s usually a signal that you have funding squeezes.”

But some say the fears are overblown.

Abrdn notes that bond market volatility is considerably higher compared to the years leading up to the pandemic, which means it’d take bigger shocks to evoke fluctuations that would impact the basis trade. Swings in Treasuries have abated in recent months but they are still almost double the level seen at the start of 2020, according to a gauge from the Intercontinental Exchange Inc. and Bank of America.

“The risks of a concentrated blow-up or unwind of these trades is somewhat diminished relative to March 2020,” said James Athey, investment director of rates management at abrdn in London. “Rates volatility is already elevated, unlike in early 2020 when the pandemic hit during a period of relative stability.”

Quantitative Tightening

Interest rate speculation aside, Citigroup Inc. reckons that quantitative tightening may also help explain why the basis trade is making a comeback. As liquidity drains from the system, asset managers are switching to futures from cash bonds for their duration exposure, giving hedge funds an opportunity to bet on the gaps between the two.

A gauge of leveraged fund futures positioning is showing net shorts around record levels, while the asset manager equivalent is almost a perfect mirror image, according to the CFTC data.

As money managers await the Fed’s next rate move, some are weighing the potential fallout if the basis trade goes pear-shaped.

Should the trade go belly up, that may cause “unintended, not needed volatility in the Treasury market,” said Hamza Ayub, portfolio manager at Farro Capital in Singapore which manages about $1 billion on behalf of wealthy Asian clients. “More hedge fund participation in basis trades probably means more liquidity and systematic risk” in Treasuries.

–With assistance from Masaki Kondo.

(Updates with Powell’s Sintra comments.)