US Treasuries Basis Trades Losing Profitability Amid Rising Funding Costs – Reuters

By Davide Barbuscia

NEW YORK – A hedge fund arbitrage trading strategy that may have intensified a crash in the global bond market in 2020 is now facing heightened regulatory scrutiny and could see a decline in popularity due to diminishing profitability, according to Oxford Economics.

The strategy, known as basis trades in U.S. Treasuries, capitalizes on the price difference between futures contracts and the underlying bonds. Typically employed by macro hedge funds with relative value strategies, basis trading involves selling a futures contract while buying deliverable Treasuries using repurchase agreement (repo) funding, only to deliver them at the contract’s expiration.

However, rising borrowing costs in the repo market have adversely affected the profitability of these trades, as noted by Javier Corominas, director of global macro strategy at Oxford Economics. He indicated that the continuous increase in actual repo rates has narrowed the gap with implied repo rates, rendering basis trades less lucrative, with the gross basis now nearing zero.

Since the Federal Reserve began raising interest rates last year, the Secured Overnight Financing Rate (SOFR) — which measures overnight borrowing costs collateralized by Treasuries — has surged. The implied repo rate, representing the return from borrowing funds to acquire an asset in the cash market and delivering it in the futures market, has similarly been impacted.

Federal Reserve economists have raised concerns about financial vulnerabilities linked to basis trades earlier this year, as leveraged funds increased their short positions in certain Treasuries futures, indicating a rise in this trading approach.

During past market stress events, such as in September 2019 when dwindling bank reserves drove overnight loan costs to as high as 10%, leverage levels in Treasuries were notably elevated, prompting intervention from the Fed. The unwinding of basis trades likely played a role in the illiquidity experienced in Treasuries in March 2020, when fears related to the coronavirus pandemic prompted the central bank to purchase $1.6 trillion in government bonds.

Recent data from the Commodity Futures Trading Commission revealed that speculators’ bearish bets on U.S. Treasury two-year note futures reached an all-time high last week. Conversely, net short positions in U.S. 10-year note futures, which had been rising broadly over the past year, have been reduced in recent weeks, reaching their lowest level since March.

Corominas concluded that a reduction in the exploitation of this spread going forward suggests a decrease in financial stability risks associated with forced sales of Treasuries in a challenging bond market scenario.