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Trust the TBAC to cut through the noise on niche but controversial markets topics like, say, the Treasury basis trade.
The Treasury Borrowing Advisory Committee, or TBAC for short, doesn’t only advise the Treasury on the obvious (borrowing practices). It also presents on more niche topics, like which types of notes to introduce/retire, auction formats and market structure.
It’s full of heavy hitters who were there to see the blow-up in the basis trade, or the arbitrage between Treasury cash and futures markets, during the dash for cash in early 2020. So it’s worth paying attention to see how they answered the following question posed by the Treasury Department ahead of its latest refunding meeting:
“According to Treasury futures positioning data, asset manager long positions and leveraged fund short positions have increased significantly. Please discuss the factors that could be driving this dynamic. What are the reasons for asset managers to prefer the Treasury futures market over the cash market for their duration needs? What type of activity does the leveraged short positioning reflect; for example, to what extent could this be cash-futures basis trading activity? What are important factors to consider when monitoring changes in cash-futures basis positions?”
Instead of zeroing in on the risks of the arbitrage’s existence, which were demonstrated very clearly in 2020, the question prompts TBAC to dig into what makes the arbitrage so profitable.
One trend that has often taken the blame for hedge funds’ increased involvement in the Treasury market is the growth in supply. But higher supply doesn’t explain why, exactly, futures trade at a premium to cash Treasuries. And that premium in futures is what makes the arbitrage opportunity so attractive to hedge funds in the first place.
For that, TBAC highlights into different market dynamic: Plain-vanilla asset managers tend to be long Treasury futures, and leveraged fund managers tend to be short. As the presentation puts it:
. . . there is a persistent risk premium to be harvested in Treasury futures basis. It appears that asset managers are willing to pay this premium to invest in higher yielding products, while hedge funds earn the premium.
In other words, asset managers’ demand for Treasury futures creates the opportunity for arbitrage, and hedge funds provide liquidity in that trade. The presentation calls it a “symbiotic relationship”.
The TBAC proposes some interesting reasons that asset managers tend to be long futures, and the full report is definitely worth checking out.
To summarise quickly, futures markets provide a cheap and efficient avenue for adding leverage and/or hedging interest-rate exposure compared to repo markets.
Remember that rates were very low in the pre-2022 world. So asset managers who wanted to juice their fund’s yield often kept larger allocations to credit than existed in the benchmark (often the Bloomberg US Agg). But credit has shorter duration by design, meaning it doesn’t carry as much interest rate risk as the benchmark for most funds. So instead of changing the fund’s entire strategy, a manager could maintain his or her duration exposure by taking leveraged Treasury positions.
In theory, this leverage could come from futures or repo markets, but the cost of repo trades are reported as interest expense, unlike repo markets. The TBAC presentation suggests that dissuades fund managers from pursuing that leverage in repo markets.
There are several implications of this, in TBAC’s view. Here are a couple of the most interesting ones:
First, “a reduction in credit risk by asset managers would naturally facilitate unwinding the basis trade by hedge funds.” This could imaginably be happening already, if asset managers are indeed retreating from the reach for yield that characterised the post-GFC. pre-Covid era.
Second, “Treasury repo clearing may provide an opportunity to gain greater insights in the coming years.” It will be interesting to see if (or how) the expansion of repo clearing affects the avenues that bond funds use to leverage. If (a big if) expanding clearing makes repo trades more standardised and easy to perform, does that remove some of the appeal of futures for fund managers?
What’s most clever here, however, is that TBAC and Treasury are looking at the conditions that create the arbitrage. Otherwise it’s a bit too easy to get mired in the argument between competing traders over who gets to perform it.
