Despite some recent unwinding, the short positions of leveraged funds in Treasury futures remain large and there are indications this is related to the basis trade, the International Monetary Fund (IMF) wrote in a recent report.
Under normal market conditions, these basis trades contribute to market liquidity and efficiency by aligning the cash and futures markets. The trade has also made the hedge fund sector a key buyer base of Treasury securities. However, the scale of this basis trade has also increased leverage in the financial system as volumes of repos have increased substantially over the past year.
Basis trade investors rely on low repo haircuts and low repo rates to leverage their positions and increase basis trade profitability. A spike in repo rates — triggered, for example, by surprises in quantitative tightening — can render the trade unprofitable and could trigger the forced selling of Treasury securities and a brisk unwinding of futures positions as funds seek to quickly delever.
Aggressive use of repo financing also makes the basis trade vulnerable to other shocks, such as upside inflationary surprises that lower the value of funds’ long bond positions, amplified by leverage.
“Of greater concern, a concentration of vulnerability has built up, as a handful of highly leveraged funds account for most of the short positions in Treasury futures. Some of these funds may have become systemically important to the Treasury and repo markets, and stresses they face could affect the broader financial system,” the IMF wrote.