Hedge funds ended October holding a record net short position in U.S. Treasuries futures, signaling their persistence with the so-called ‘basis trade’, although the steep plunge in yields since then may force a substantial reversal in the coming weeks.
The latest Commodity Futures Trading Commission (CFTC) figures show that speculators, especially leveraged funds, ramped up their short Treasuries positions in the week ending Oct. 31, most notably at the short end of the curve.
This fits with the ‘basis trade’, a leveraged arbitrage play profiting from price differences between cash bonds and futures that speculators have been doing for much of this year.
Regulators have expressed concern about the financial stability risks a sharp and disorderly unwind of these bets could pose in an adverse bond market scenario.
Leveraged funds - those speculators more active in the basis trade - increased their combined net short position in two-, five- and 10-year Treasuries futures by more than 300,000 contracts to nearly 5 million contracts, CFTC data show.
That is significantly larger than the peak combined net short position from 2019 of just over 4 million contracts, boosted by fresh record short positions in the two- and five-year space.
In October leveraged funds increased their net short position in two-year futures by 242,000 contracts to 1.6 million contracts, and by 193,000 contracts in five-year futures to 1.93 million. Both these totals are fresh records.
They only grew their net short position in 10-year futures by 10,000 contracts, however. ‘Non-commercial’ accounts, often seen as a broader grouping of CFTC hedge funds and speculators, actually cut their 10-year net shorts for a second month.
A short position is essentially a wager an asset’s price will fall, and a long position is a bet it will rise. In bonds falling prices indicate higher yields, and vice versa.
But funds play Treasuries futures for other reasons, like relative value trades, and this year, the basis trade. The difference between cash bond and futures prices is tiny, but funds make their money from leverage in the repo market and sheer volume of trade.
That trade may be running out of steam. Its profitability has been dented recently by rising borrowing costs in the repo market, according to Javier Corominas at Oxford Economics.
On top of that, the sharp rally in bonds, on growing hopes of a U.S. economic ‘soft landing’ and less onerous borrowing needs for the Treasury, will almost certainly be shaking out some of these short positions.
Yields have slumped as much as 50 basis points, markets no longer expect any more rate hikes, and around 75 basis points of easing is priced into the 2024 rates futures curve, starting in June.
Citi’s U.S. rates strategy team expects Treasuries to continue rallying this week. They cite softer economic data, dovish signals from Fed Chair Jerome Powell, and a better-than-expected refunding outlook from Treasury.
“This puts the brake on momentum-driven selling,” they wrote on Friday. “The question we’re being asked is – have yields peaked? We think so, given our valuation anchors and the extent to which momentum and sentiment has shifted over the last week.”
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