Who’s afraid of the Treasury basis trade?

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Parts of FT Alphaville have been worrying about Treasury basis trades long before it became cool, after watching in slack-jawed fear the financial cataclysm that almost occurred in March 2020.

More recently, the Bank of England, the Bank for International Settlement, and the Federal Reserve itself have all highlighted how Treasury bonds/futures arbitrage strategies have been staging a comeback, as well as the risks that poses. We’ve also joined in, naturally, as have our friends on the Unhedged podcast.

The chart showing the overall hedge fund short interest in Treasuries — a reasonable though flawed proxy for the popularity of the trades — is certainly eye-catching.

But a report from Goldman Sachs’ rates strategy team from Friday makes a very good point in favour of calm: these basis trades are much less leveraged than they were before, and that probably matters more than their overall size.

We do not think the trade poses a major risk to Treasury markets in the near term . . . Leverage in the system is materially lower than it was in 2019/20 as a result of a series of [initial margin] increases (and price declines). The large increases in IM, which were in theory calibrated to the extremely elevated levels of Treasury market volatility of the past few years, should mean additional large increases may not be necessary — at least in the near term, we expect to migrate to a less volatile rate regime.

This might need a bit of unpicking, so here goes: The Treasury basis trade is buying Treasuries and selling the associated futures contract, and pocketing a slight price differential between the two (this is the basis).

Despite being economically the same (the first can be delivered to satisfy the second on maturity), the actual Treasury bonds tends to be cheaper than the futures contracts because of issues like different regulatory treatment, and the ease of getting extra leverage with futures.

Because the basis is usually pretty small, hedge funds usually use a LOT of leverage. They get this by swapping the Treasuries they buy for more cash in the repo market, and recycle it into new positions. Repeat it enough times and you can turn a small basis into a very lucrative trade.

Problems can arise if the spread between the two widens rather than narrows — as happened in March 2020 when there was a mad “dash for cash” from foreign central banks and other big investors that suddenly liquidated Treasuries to raise money in a hurry.

The resulting volatility causes margin requirements to be increased, and can force hedge funds into ratcheting back their positions, widening spreads further, leading to more margin calls etc. A classic doom loop, in other words.

But as Goldman’s Praveen Korapaty et al point out, the US government bond market has been pretty choppy for a while now. Here is the BofA MOVE index of implied volatility of the US Treasury market (basically the bond equivalent of the Vix index).

This means that the initial margin that people need to pony up for shorting Treasury futures is higher as well, and means that although the absolute size of the Treasury basis trade might be high, it is less susceptible to quick unwinds due to the lower leverage.

Here is Goldman’s chart showing the ratio of contract prices (which is also lower than before given the Treasury sell-off) to initial margins. FV is the five-year Treasury futures contract, TY is the 10-year contract, and WN is the 25-year plus contract.

Goldman therefore reckons that even if regulators decide to impose higher margins to tame the dangers of another Treasury basis trade unwind it won’t have much of an impact.

To be sure, margin increases could be mandated on the cash leg as part of a regulatory push, but the lower leverage levels will mean the magnitude of unwinds that are triggered will likely be smaller. From a financing perspective, the presence of sizable RRP balances will likely prevent significant increases in repo financing spreads for a while. Therefore, although the buildup in basis positions bears watching, it does not appear particularly concerning to us at the moment. More fundamentally, the position is the result of structural mismatches between the form in which duration is supplied versus the format in which it is desired, and is unlikely to be eliminated, in our view — mandating lower leverage will simply mean a wider basis.

We’re not entirely reassured, as this is just looking at the futures contract leverage part of the equation. If repo markets go haywire then you could still a very quick, very brutal unravelling of Treasury basis trades.

But given the current angst surrounding the issue, the Goldman note adds a note of welcome nuance that is probably worth highlighting.