Hedge Funds Pull Back from Treasury Basis Trade as Profitability Declines

Hedge funds are scaling back their leveraged Treasury basis trades as declining profitability and improved market conditions reduce the appeal of the strategy. Funds committed to the trades have fallen 20% this year to $1.2 trillion, according to Morgan Stanley estimates. The strategy involves borrowing overnight to purchase US Treasury securities while selling corresponding futures to profit from small price differences. Although the trade has previously raised concerns about systemic risks due to heavy leverage and potential margin calls, the current pullback has largely reflected weaker trading opportunities and moderating demand for Treasury futures.

The decline has been concentrated mainly in futures linked to two-year and five-year Treasury maturities, according to Morgan Stanley analysts. Hedge funds’ net short positions in two-year Treasury futures have dropped more than 40% from a 15-month high in March, while asset managers’ net long positions have declined more than 30% from their record high during the same month. Meanwhile, softer demand for Treasury securities and futures, increased inventories at major bank dealers and US Treasury buybacks have further narrowed potential gains. Analysts noted that reduced asset manager demand for long Treasury positions has made it more difficult for hedge funds to establish profitable basis trades.

Despite the decline, the Treasury basis trade remains a significant presence in financial markets, with large hedge funds continuing to maintain substantial exposure. The strategy has drawn renewed scrutiny from the Federal Reserve Bank of New York over potential systemic risks. However, Morgan Stanley said there is no evidence of broad market stress linked to the trade in the current cycle. Recent changes to supplementary leverage ratio (SLR) requirements have also enabled major banks to hold larger Treasury inventories, improving market liquidity while reducing some of the pricing opportunities basis traders traditionally exploit. Morgan Stanley analysts maintain that although returns have weakened and positions have declined, the trade remains active.

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