By Jamie McGeever
ORLANDO, Florida (Reuters) – As the first U.S. interest rate cut in this cycle draws closer, long and short positions in the Treasury futures market, and overnight repo lending volumes, have never been higher.
And these record numbers could get even bigger if the Fed can deliver a soft landing for the economy – something it’s only ever really done once before, in the 1990s.
Is this a cause for concern? As is the case in any financial market, the security of investors’ positioning depends on two key factors: volatility and liquidity. Right now Treasury market volatility appears subdued and liquidity appears ample.
On one side of the trade, asset managers, pension funds and institutional investors are hoovering up risk-free government bonds to lock into attractive yields before they start falling in tandem with the policy rate. They do this by going ‘long’ bonds in the liquid Treasury futures market.
On the other side, hedge funds are ‘short’ and selling the futures, hedging their exposure by buying equivalent and slightly cheaper cash bonds with funds borrowed in the highly leveraged overnight repo market. Pocketing the tiny price difference between futures and cash bonds is known as the ‘basis trade’.
Regulators from the Bank for International Settlements to the Bank of England have warned about the financial stability risks that a sudden unwind in these positions could trigger.
While this is a dog that hasn’t barked, far less bitten, the numbers involved now are eye-watering, in nominal and relative terms.
Commodity Futures Trading Commission figures show that asset managers’ aggregate long position across two-, five- and 10-year futures is worth $1.1 trillion, and leveraged funds’ corresponding short position totals $1.05 trillion. These are record amounts, dominated by activity at the interest rate-sensitive shorter end of the curve.
As a share of total open interest, asset manager longs are 55% and leveraged fund shorts are 52%. In February 2020, just before the basis trade last blew up, asset manager longs were 42% of open interest and hedge fund shorts were 38%.
Regulators’ concerns are not unwarranted.
New York Fed data, meanwhile, shows that the amount of overnight cash borrowed at the Secured Overnight Financing Rate (SOFR) last month hit a record $2.175 trillion. This is a sign that investors are leveraging up purchases of cash bonds to hedge their short futures position.
“Repo volumes…
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