Wall Street Arbitrage Myth Fades! Hedge Funds Begin Unwinding Popular U.S. Treasury Trade

The 'basis trade,' the most popular strategy among hedge funds in the U.S. Treasury market in recent years, is gradually losing its appeal. As the price spread between U.S. Treasury futures and cash bonds narrows, the room for arbitrage is being squeezed, with some traders even stating that this trade is nearing its limit.

The basis trade typically exploits the small price difference where U.S. Treasury futures trade slightly above cash bonds. Hedge funds buy cash Treasuries while simultaneously shorting Treasury futures, leveraging borrowed funds from the repo market to amplify returns. Because the individual price spread is extremely small, this strategy relies heavily on leverage and low-cost financing.

Morgan Stanley estimates that leveraged investors have reduced their exposure to the basis trade by over $200 billion in recent months, bringing total investments to around $1 trillion. Data from the U.S. Commodity Futures Trading Commission (CFTC) also shows declining net short positions by leveraged funds on various U.S. Treasury futures, while trading volume in certain repo markets used by hedge funds for financing has also decreased.

Eli Carter, U.S. interest rate strategist at Morgan Stanley, said the stagnation in the growth of basis trade activity suggests the market may be approaching its maximum capacity. Chris Horvatin, head of U.S. repo operations at Goldman Sachs, revealed that some clients have complained the basis trade is 'already dead,' no longer offering sufficiently attractive returns.

While the basis trade still stands at around $1 trillion and has not disappeared entirely, its growth momentum has clearly slowed. If this trend continues, it could alter the structure of the $31 trillion U.S. Treasury market. In recent years, this market has become increasingly reliant on hedge funds for liquidity, with major players including Millennium Management, ExodusPoint, Citadel, and Capula.

The cooling of the basis trade is driven by multiple factors, including Wall Street banks increasing their Treasury holdings, asset managers reducing demand for Treasury futures, the U.S. Treasury shifting issuance toward short-term T-bills, and the Fed halting its balance sheet runoff. These changes reduce market mispricing and weaken the incentive for hedge funds to make large bets.

The Trump administration's push for financial deregulation led regulators to relax the 'enhanced supplementary leverage ratio' (eSLR) rules, allowing banks greater capacity to hold U.S. Treasuries. Wall Street dealers' net long Treasury positions hit record highs earlier this year and remain significantly above last year's levels.

Banks typically short Treasury futures to hedge against falling bond prices. Although their purpose differs from hedge fund arbitrage, the resulting trade combination has a similar economic effect to the basis trade, further compressing the spread between futures and cash bonds.

Additionally, after the U.S. and Israel attacked Iran at the end of February, market expectations for Fed policy shifted from rate cuts to rate hikes, prompting asset managers to reduce their long positions in short-dated Treasury futures. Weaker futures demand reduced their premium over cash Treasuries, lowering the potential returns of the basis trade.

The retreat of hedge funds from the basis trade is not necessarily all bad. Regulators have long worried that the U.S. Treasury market's heavy reliance on highly leveraged funds could trigger a wave of forced unwinding during market stress. During the market turmoil in March 2020, hedge funds rapidly unwound basis trades, exacerbating Treasury market dysfunction and forcing government and Fed intervention.

Amrut Nashikkar, head of rates derivatives research at Barclays, believes that reduced dependence on hedge fund leverage makes the market less prone to 'destabilizing feedback loops' under stress. With a more diverse set of participants, the likelihood of simultaneous exits decreases, suggesting that the systemic vulnerability created by Treasury futures basis trades may already be lower.

However, if economic conditions change and markets resume betting on Fed rate cuts, asset managers' demand for Treasury futures could rebound, reviving spreads and reactivating the basis trade. Whether this $1 trillion trade is merely taking a temporary pause or has passed its peak remains to be seen.