A leveraged trade in US Treasury futures that has become popular among hedge funds poses a risk to global financial stability, according to the Bank of England.
(Bloomberg) — A leveraged trade in US Treasury futures that has become popular among hedge funds poses a risk to global financial stability, according to the Bank of England.
Short positions in Treasury futures by leveraged investors have increased in recent months, the central bank said in its Financial Stability Report Wednesday. Market intelligence suggests these bets are “relative to bonds or swaps” and if prices were to move sharply, deleveraging the positions could further amplify stress, it said.
Hedge funds often look to exploit the pricing difference between cash bonds and futures in a strategy known as the basis trade, which sees them bolster returns by borrowing money in the repo market. The bets tend to work well in a low volatility environment, but backfired in March 2020 when the pandemic triggered a stampede into US bond futures.
Such risks “remain largely unaddressed and could resurface rapidly,” the BOE said. “In particular, the sharp transition to higher interest rates and currently high volatility increases the likelihood that market-based finance vulnerabilities crystallize and pose risks to financial stability.”
Read more: Notorious Hedge Fund Trade Puts Bond Bulls on Steepening Watch
The warning comes amid increased scrutiny on financial stability risks posed by non-banks. That follows a historic rout in the UK bond market in September related to a leveraged strategy used by pension funds and the “dash-for-cash” in March 2020. The BOE released details last month on its expanded stress tests that now include hedge funds and pension firms.
In the US, officials at the Securities and Exchange Commission and the Federal Reserve have questioned prime brokers about the basis trade, Bloomberg reported in May. Hedge funds active in the trade included Citadel, Millennium Management, ExodusPoint Capital Management and Capula Investment Management, people familiar with the matter said at the time.
Treasuries positioning since then suggests leveraged traders have kept adding to their basis trade bets, in part facilitated by asset managers who’ve piled into the other side of the wager to hedge their interest-rate exposure.
–With assistance from Ruth Carson.
(Adds context on US regulatory scrutiny in sixth paragraph.)
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