Hedge funds are expanding basis trades, data suggests

A surge in short sales of US Treasury futures suggests hedge funds are expanding basis trades, a popular tactic that may be injecting leverage into a bond market whipsawed in the wake of this month’s selloff. 

The revival of the trade — which exploits price differences between futures and underlying bonds — was likely behind the positioning by hedge funds up to Aug. 22, when the latest Commodity Futures Trading Commission data shows their short positions swelled to over 6 million 10-year-note futures equivalents. Asset managers are net long to a similar degree. 

The positioning data indicates an inrush into basis trades just as the most recent Treasury selloff was cresting, pushing 10-year yields to the highest since the before 2008 credit crisis. The proliferation of such leveraged strategies could exacerbate the market’s volatility, as happened in previous cases when they were rapidly unwound. 

Bank of America Corp. strategists said this week that momentum strategies, which also rely on leverage to amplify returns, are also likely on the rise.  

Meanwhile, asset managers’ long positions reflect continued inflows into Treasury funds and buying during the latest backup in yields, according to Bank of America. That type of dip buying — as well as purchases to close out short positions — may have fueled the Treasury rally Tuesday following a report showing that job openings declined at a sharper-than-expected pace.

Yet there appears diminished conviction about were yields are heading. The latest JPMorgan Chase & Co. Treasury client survey up to Aug. 28 shows a reduction in both long and short positions, with neutrals the most elevated in over a month. 

Meanwhile, block-trade activity continues to soar with focus on the 5-year note futures. That segment of the cash curve has been in focus recently amid signs of growing short positions there. 

Here’s a rundown of positioning in various corners of the market:

REAL MONEY, FAST MONEY DIVERGE

In CFTC data up to Aug. 22, leveraged fast money accounts added over 100,000 10-year note futures equivalents to net duration shorts over the week. That widened the divergence with asset managers, with so-called real money buyers adding over 50,000 10-year futures equivalents to net long positions. 

BLOCK TRADES POPULAR, FOCUS ON 5Y

In data stretching from Aug. 21 to Aug. 28, block-trade activity in 5-year note futures surged relative to trading seen over rest of the curve. Some portion of the activity was reflected by curve trades, with notable demand seen for flatteners over the reporting period. For example a $850k/DV01 5s30s flattener and similar trades in sizes of $860k/DV01 and $635k/DV01. 

HEDGING FOR TREASURY SELLOFF CHEAPENS

The cost of hedging a rise in long-end yields continues to cheapen relative to the rest of the Treasury curve, shown by a tightening in the skew levels in options for long-bond futures.

SOFR OPTIONS

The most active SOFR options strike out to March 2024 remains the 95.00, where recent activity around this level has included a buyer of the 94.875/95.00/95.125/95.25 call condor. Also, last week the SOFR Dec23 94.375/95.00 1x3 call spread bought, targeting rate-cut hedges, which has been a popular theme in SOFR options over the past week. Additional to this the SOFR Dec23 94.50/94.75/95.00 call fly and Mar24 94.75/95.00/95.25 call fly have also been popular.