By David Barbuscia
NEW YORK (Reuters) – An expected increase in Treasury bond issuance could put a damper on hedge fund transactions that have led to record short positions, potentially disrupting bond markets if speculators quickly unwind their holdings.
In recent weeks, hedge funds have taken large leveraged short positions in some Treasury bill futures – contracts to buy and sell bonds for future delivery – as part of a so-called basis trading that takes advantage of a difference between the price of cash and forward bonds, analysts say. The difference stems in part from asset manager demand for Treasury bill futures, which could be driven by economic concerns, analysts said.
However, new issuances of government bonds could drive up rates in short-term funding markets where hedge funds leverage their holdings, which could lead to an unwinding of this positioning. That, in turn, could put pressure on bonds or even force the Federal Reserve to intervene, analysts warned.
“That could be a risk for this type of trade that forces a lot of these funds to close these basic trades and then create shock waves throughout the market,” said Gennadiy Goldberg, head of US rates strategy at TD Securities USA.
The recent resolution of the US debt ceiling extension debate means that sales of Treasury bills are expected to reach around $1 trillion by the end of the year, as the general account of the Treasury ( TGA) is reconstituted. Typically, an increase in government borrowing drains reserves from the banking system and, as banks absorb new issues, they have less money to lend.
This scenario could lead to a spike in rates in the repurchase agreement (repo) market, similar to what happened in September 2019. This is when falling reserves led to an increase in the cost that banks and other market participants pay to raise overnight loans. finance their transactions, forcing the Fed to intervene by injecting liquidity into the repo markets.
“Less liquidity could mean a shift in supply and demand in the repo market,” with hedge funds potentially facing higher rates simply because there is less liquidity in the system to lend, a said Steven Zeng, US rates strategist at Deutsche Bank.
In this case, a large but orderly unwinding of hedge fund positions in Treasuries could drive up yields relative to other fixed-income instruments, he added. “A bad result … would be a disorderly outcome of these exchanges, forcing the Fed to intervene.”
Certainly, the risk of liquidity depletion would decrease if money market funds absorbed the new issuance of Treasuries by reducing their investments in the Fed’s reverse repo facility (RRP), where they store their cash.
But some analysts worry that bank reserves could decline if Treasuries fail to offer yields above the RRP or if expectations of further interest rate hikes discourage money market funds from extending the duration of their investments.
US Treasury Secretary Janet Yellen said last week that her department was watching for signs of market disruptions as the government built up its cash balance through Treasury bills.
Fed Chairman Jerome Powell also told a news conference last week that the Fed would “watch market conditions carefully” while the Treasury topped up its balance.
BASIC TRADE
Relative value hedge funds and macro managers are typical hedge funds that enter into basis transactions, which work by selling a futures contract, buying treasury bills deliverable in that contract with repo funding and delivering at the end of the contract. The unwinding of core trade positions contributed to the illiquidity of Treasuries in March 2020, when the market seized up amid growing pandemic fears, prompting the Fed to buy $1.6 trillion in bonds of state.
Data from the Commodity Futures Trading Commission (CFTC) at the end of May showed that speculators’ bearish bets on two-, five- and ten-year US Treasury bonds had reached their highest level ever. Some of those shorts were discounted, but net shorts on two-year ratings hit a new high in the week ending June 13.
Some hedge funds may short Treasury bills due to macroeconomic assumptions.
“Quantitative hedge funds have shorted Treasuries because trend patterns continue to point to a downward price trend and discretionary hedge funds see negatives, such as inflation, a labor market tense and the hawkish Fed,” said Deepak Gurnani, founder and managing partner of hedge fund Versor Investments. .
But according to several analysts, the recent accumulation of shorts was more the result of an arbitrage opportunity than an indication of speculator bets on the direction of rates.
The accumulation of shorts coincided with increased use of the repo market.
Trading volume underlying the collateralized overnight funding rate (SOFR), which is a measure of the cost of borrowing overnight cash backed by treasury bills, has grown rapidly this year, according to New York Federal Reserve data.
SOFR volume topped $1.6 trillion on June 1 — the highest since the New York Fed began posting the rate in 2018.
“These data correlate very well with the short positions of leveraged investors, suggesting that leveraged funds are long cash treasuries and short futures,” said Deutsche’s Zeng. Bank.
(Reporting by Davide Barbuscia in New York; Additional reporting by Carolina Mandl in New York; Editing by Megan Davies and Matthew Lewis)