Hedge Funds and Leveraged Positions in the Treasury Market

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The use of leveraged positions in the $25.1 trillion Treasury market by hedge funds is once again under scrutiny. This time, a prominent Wall Street firm is warning of potential consequences if these trades are quickly unwound.

According to strategist Steven Zeng of Deutsche Bank, such an unwinding scenario would trigger a repeat of the Treasury market volatility that occurred in March 2020 – something that the Federal Reserve is keen to avoid.

The basis trade, often employed as an arbitrage maneuver, involves holding a short Treasury futures position, a long Treasury cash position, and borrowing in the repo market to finance the trade and provide leverage.

Hedge funds have increasingly turned to this basis trade method to exploit price discrepancies between Treasury futures and cash Treasurys. However, these moves have caught the attention of the Federal Reserve Board and Treasury Department, who are closely scrutinizing such activities.

For these fast-money hedge funds, the basis trade has become a crucial tool to extend short positions in the Treasury market while expressing confidence in the overall strength of the U.S. economy.

Deutsche Bank’s Zeng highlights the fact that leveraged fund shorts have reached new record levels, raising concerns about how these positions will be unwound. One potential adverse scenario arises from a sudden rise in Treasury futures prices due to a significant weakening in the U.S. economy. This could force a rapid unwinding of the basis trade, known as a “rinse out” of these positions.

It is clear that hedge funds’ utilization of leveraged Treasury trades demands diligent monitoring, as outlined in a recent paper from the Federal Reserve. The potential consequences of unwinding these positions must be carefully managed to avoid market volatility and disruptions.

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