Researchers at the Federal Reserve have issued warnings in recent weeks about possible disruptions in U.S. Treasuries due to hedge funds' short positions hitting a record high with basis trades

Researchers at the Federal Reserve have issued warnings in recent weeks about possible disruptions in U.S. Treasuries due to hedge funds' short positions hitting a record high with basis trades, per Reuters.

In recent weeks, researchers at the Federal Reserve have issued cautions regarding potential disruptions in the U.S. Treasuries market, primarily linked to the resurgence of a popular hedge fund trading strategy that exacerbated a significant bond market crash in 2020.

Hedge funds have been establishing substantial short positions in certain Treasuries futures, notably reaching record highs, as part of what is known as basis trades. These trades exploit the premium of futures contracts over the price of the underlying bonds and have typically been associated with macro hedge funds employing relative value strategies. The essence of these trades involves selling a futures contract, purchasing the corresponding Treasuries deliverable upon contract expiration using repurchase agreement (repo) funding, and ultimately delivering them upon contract maturity.

In two separate communications over recent weeks, economists at the Federal Reserve have underscored potential financial vulnerabilities linked to these trades. They have expressed concerns as these activities occur amidst market volatility in the U.S. government bond market, driven by rising interest rates and uncertainty surrounding future monetary policy actions.

According to the Fed economists, "Cash-futures basis positions could again be exposed to stress during broader market corrections," as stated in an August 30 note. They further emphasized the need for vigilant monitoring of these trades in light of these risks.

Additionally, in a September 8 note that assessed various aspects of hedge funds' Treasury exposures, the Fed economists highlighted the potential for a swift unwinding of basis trade positions in the event of elevated repo funding costs. Such a scenario could exacerbate market stress, potentially leading to heightened volatility in the Treasury market and amplifying disruptions in the Treasury, futures, and repo markets.

Data from the Commodity Futures Trading Commission (CFTC) indicated that leveraged funds had amassed near-record-high net short positions in specific Treasuries futures in recent weeks, a trend mirrored by substantial long positions from large asset managers, indicative of their involvement in basis trades.

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