Hedge funds’ growing use of leveraged positions in the $25.1 trillion Treasury market is back in the spotlight again, this time with one major Wall Street firm warning of what might happen if those trades are rapidly unwound.
In a note released on Tuesday, strategist Steven Zeng of Deutsche Bank
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said such a scenario would essentially lead to a repeat of the Treasury market volatility that occurred in March 2020 and is something that the Federal Reserve “wants to avoid.”
The basis trade is an arbitrage maneuver that involves a short Treasury futures position, a long Treasury cash position, and borrowing in the repo market to finance the trade and provide leverage. Hedge funds have increasingly used the basis trade as a way to arbitrage the price differences between Treasury futures and cash Treasurys — moves that are now drawing scrutiny from the staff of the Federal Reserve Board and Treasury Department.
Read: Hedge funds’ use of leveraged Treasury trades needs ‘diligent monitoring,’ Fed paper says
See also: Asset managers and hedge funds are increasingly taking different positions in the U.S. Treasury market
The trade is one of the major ways in which hedge funds, known as the fast-money crowd, have been able to extend short positions in the Treasury market and express overall confidence in the U.S. economy.
Leveraged fund shorts “have risen to new record heights” and one important question is how the positions will be unwound, Deutsche Bank’s Zeng wrote. He said one adverse scenario would arise from a “rinse out of these positions,” which could happen if Treasury futures prices suddenly rise as the result of a significant weakening of the U.S. economy and force a rapid unwind of the basis trade.
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