$1trln basis trade has barely barked, let alone bitten: McGeever

Zawya

08-05-2025

(The opinions expressed here are those of the author, a columnist for Reuters)
ORLANDO, Florida - Amid all the uncertainty surrounding U.S. growth, Federal Reserve policy, and the attractiveness of the dollar, the U.S. bond market is remarkably tranquil, calling into question long-held fears about the massive 'basis trade'.
While Treasuries experienced a brief bout of volatility following the Trump administration's 'Liberation Day' tariffs last month, including a spike in long-term yields and dislocation in 30-year swap spreads, the $29 trillion market has withstood everything thrown at it.
Indeed, positioning in Treasury futures has quietly risen in recent weeks and is now close to a record aggregate peak across two-, five- and 10-year contracts. In the five-year space, both 'long' and 'short' positions have never been higher.
The Treasury futures market is where hedge funds operate the basis trade, an arbitrage that profits from making highly levered bets on tiny differences between the price of cash bonds and futures.
Global financial authorities have repeatedly warned that, if suddenly unwound, these positions – levered up to 100 times – could pose a threat to financial stability, as sharp price swings could trigger a devastating dash for cash and scramble to cover.
But that hasn't happened yet, despite all the market volatility over the past month.
Instead asset managers and leveraged funds are steadily building their 'long' and 'short' positions, respectively. Aggregate holdings across two-, five- and 10-year futures contracts are all comfortably above $1 trillion in notional terms. Speculators seem happy to continue peeling off the pips in the basis trade, and asset managers are happy to lock in yields between 3.80% and 4.20%.
"It's maybe a little surprising how fast these positions are being rebuilt, but it shows a generally salient view leveraged investors have in the functioning of the repo and Treasury markets," says Steven Zeng at Deutsche Bank.
SOLID FOUNDATIONS
Treasury market depth may be a bit thinner than normal but it's nowhere near crisis levels, and there's no sign of the funding stress of late 2018, or September 2019 when the Fed was forced to inject liquidity into the market.
The 'MOVE' index of implied Treasury market volatility has come down almost as quickly as it spiked in early April and is now below its average of the last three years.
Overnight repo rates, which hedge funds can use to fund the basis trades, spiked at the height of the tariff turmoil a month ago, but that was an insignificant blip compared to the surges in 2018 and 2019. Repo rates are now in the middle of the Fed's 4.25-4.50% policy target range.
Meanwhile, New York Fed data shows that the volumes of overnight cash borrowed at the Secured Overnight Financing Rate (SOFR) hit a record $2.8 trillion at the end of April. That suggests liquidity is ample, demand is strong and investors have confidence in this source of funding. These all appear to be signs of a well-functioning market.
True, there is some sign of elevated anxiety in the Treasury market. The 'term premium' - the risk premium investors demand for buying longer-dated bonds rather than rolling over short-dated loans - has risen to the highest in a decade.
And there is always the risk that a sharp spike in borrowing costs – perhaps driven by another policy surprise or twist in the ongoing trade war – could put the basis trade in peril. But then what?
If things did start to unravel, the Federal Reserve or Treasury Department would almost certainly come in with a backstop to preserve financial stability and maintain bond market functioning.
So despite the fearmongering, the $1 trillion 'basis trade' remains the dog that has barely barked, let alone bitten. Perhaps the deepest and most liquid market in the world is simply more robust than some Cassandras would have you believe.
(The opinions expressed here are those of the author, a columnist for Reuters)
(By Jamie McGeever )