In a recent note, the Fed showed that hedge fund futures and repo positions are consistent with increased trading in the cash-futures basis. The authors emphasized these developments are not enough to conclusively determine the scale of hedge fund basis trade activity. However, they note that conditions are similar to those that prevailed in 2018 and 2019, when hedge fund basis trades grew rapidly.
Specifically, increases in interest rates away from the zero lower bound may have contributed to hedging demand by asset managers. If the basis trade is reemerging, it would suggest that this hedging demand indeed plays a large role in driving the volumes in the trade.
They also note that, since the data ending date of May 9th, 2023, when this note was drafted, hedge fund short futures positions have continued to rise. This increase has been particularly prominent in the 2-year contract; between May 9th, 2023, and June 13th, 2023, hedge fund 2-year short Treasury futures rose by $94 billion, reaching a level only $65 billion lower than their all-time high.
Should these positions represent basis trades, sustained large exposures by hedge funds present a financial stability vulnerability. While the contribution of sales from the basis trade to March 2020 Treasury market liquidity remains debated, several papers suggest that absent prompt intervention by the Federal Reserve, the situation may have been far worse.
At present, measures suggest the Treasury market remains volatile, with the MOVE index still at levels comparable to the peak of March 2020. Consequently, cash-futures basis positions could again be exposed to stress during broader market corrections. With these risks in mind, the trade warrants continued and diligent monitoring.