The basis trade is effectively a leveraged trade where hedge funds hold treasuries, funded by repeatedly borrowing money overnight, and sell a contract which requires them to “deliver” a treasury to the contract holder in the future.
In the past year, these hedge funds have been a major source of demand for Treasuries, holding over 1 trillion and engaging in maturity transformation where they borrow short and lend long.
This creates a problem, because as their demand for government debt falls and the trade unwinds, we have a large amount of “short” money and “long” assets without a maturity transformation. Thus in the near term Treasury rates are becoming disassociated with the expected path of the short rates.
It isn’t unsolvable though, and will be addressed. As in a similar unwinding in March 2020 the Fed could step in and buy treasuries, or, once the rates rise enough, other firms/investors willing to do the maturity transformation may step in.
Treasury basis trade: buy cash treasuries, sell treasury futures. Collect the tiny spread. Borrow capital against the cash treasuries, use the capital to buy more cash treasuries and sell more futures. Repeat. You’re leveraging a trade that collects a small spread. But borrowing that capital requires overnight funding. If funding markets dry up or the market gets stressed, funds may have to unwind this trade quickly. This involves selling A LOT of cash treasuries at a time that there may not be much demand. Since they don’t have a choice because they need the cash, the traders will sell the cash treasuries at whatever price they can. When the price goes down as they continue selling, yields are simultaneously going up.
Comments
The basis trade is effectively a leveraged trade where hedge funds hold treasuries, funded by repeatedly borrowing money overnight, and sell a contract which requires them to “deliver” a treasury to the contract holder in the future.
In the past year, these hedge funds have been a major source of demand for Treasuries, holding over 1 trillion and engaging in maturity transformation where they borrow short and lend long.
This creates a problem, because as their demand for government debt falls and the trade unwinds, we have a large amount of “short” money and “long” assets without a maturity transformation. Thus in the near term Treasury rates are becoming disassociated with the expected path of the short rates.
It isn’t unsolvable though, and will be addressed. As in a similar unwinding in March 2020 the Fed could step in and buy treasuries, or, once the rates rise enough, other firms/investors willing to do the maturity transformation may step in.
Treasury basis trade: buy cash treasuries, sell treasury futures. Collect the tiny spread. Borrow capital against the cash treasuries, use the capital to buy more cash treasuries and sell more futures. Repeat. You’re leveraging a trade that collects a small spread. But borrowing that capital requires overnight funding. If funding markets dry up or the market gets stressed, funds may have to unwind this trade quickly. This involves selling A LOT of cash treasuries at a time that there may not be much demand. Since they don’t have a choice because they need the cash, the traders will sell the cash treasuries at whatever price they can. When the price goes down as they continue selling, yields are simultaneously going up.