US Treasury Bond; NEW YORK, 21 JUNE (Reuters) – A boom in Treasury bill supply is forecast, which could stymie hedge fund transactions that have resulted in record short positions, possibly destabilising bond markets if speculators swiftly unwind their holdings.
Analysts say hedge funds have taken significant short leveraged positions in some Treasuries futures – contracts (US Treasury) for the purchase and sale of bonds for future delivery – in recent weeks as part of a basis trade that exploits a difference in the price of cash bonds and futures. According to observers, the disparity is due in part to asset managers’ demand for Treasuries futures, which might be attributable to economic concerns.
New government bond issuance, on the other hand, might raise rates in short-term financing markets (US Treasury) where hedge funds leverage their holdings, potentially leading to an unwind of this posture. Analysts have warned that this might put pressure on bonds and potentially push the Federal Reserve to act.
“This could be one risk to that kind of trade developing that forces a lot of these funds to close these basis trades and then create shock waves throughout the market,” said Gennadiy Goldberg, TD Securities USA’s director of U.S. rates strategy (US Treasury).
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The recent conclusion of the US battle over raising the debt ceiling means that Treasury bill sales are expected to reach $1 trillion by the end of the year when the Treasury General Account (TGA) is replenished. In general, a spike in government borrowing depletes banking system reserves, and because banks absorb the new issue, they have less money to lend.
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This situation might result in a rate increase in the repurchase agreement (repo) market, similar to what occurred in September 2019. When reserves fell, the cost for banks and other market participants to raise overnight loans to support their trades increased, compelling the Fed to intervene by infusing liquidity into repo markets.
According to Steven Zeng, U.S. rates strategist at Deutsche Bank, “less liquidity could mean a shift in the supply and demand of the repo market,” with hedge funds potentially facing higher rates simply because there is less cash in the system to lend.
In such situation, he warned, a big but orderly liquidation of hedge funds‘ Treasuries bets might push rates higher relative to other fixed-income products. “A bad outcome would be a disorderly unwinding of these trades, forcing the Fed to intervene.”
To be sure, the probability of liquidity drain would be reduced if money market funds reduced their investments in the Fed’s reverse repo facility (RRP), where they keep their cash.
However, some experts are concerned that bank reserves would fall if Treasury bills do not provide greater yields than the RRP or if prospects of more interest rate rises dissuade money funds from extending the period of their investments.
Last week, US Treasury Secretary Janet Yellen stated that her agency was looking for evidence of market disturbances while the government rebuilt its cash position through Treasury bills.
Fed Chair Jerome Powell also stated at a news conference last week that the Fed will “carefully monitor market conditions” while the Treasury replenishes its balance.
BASIS TRADE
Relative value hedge funds and macro managers are examples of hedge funds that engage in basis trades, which include selling a futures contract, purchasing Treasuries deliverable into that contract using repo funding, and delivering them at contract expiration. The unwinding of basis trade positions contributed to illiquidity in Treasuries in March 2020, when the market froze due to mounting pandemic worries, leading the Fed to purchase $1.6 trillion in government bonds.
Data from the Commodity Futures Trading Commission (CFTC) at the end of May indicated that speculators‘ negative bets on US Treasury two-year, five-year, and 10-year bonds had reached their highest level ever. While some of those shorts have been reduced, net shorts on two-year notes reached a new high in the week ending June 13.
“Quantitative hedge funds have been shorting Treasuries because trend models continue to indicate a price decline, and discretionary hedge funds see negatives such as inflation, a tight labour market, and a hawkish Fed,” said Deepak Gurnani, founder and managing partner of hedge fund Versor Investments.
However, other experts believe that the recent increase in shorts was due to an arbitrage opportunity rather than speculators’ wagers on the direction of rates.
Shorts accumulation has correlated with greater usage of the repo market.
According to statistics from the New York Federal Reserve, the volume of transactions underpinning the Secured Overnight Financing Rate (SOFR), which is a measure of the cost of borrowing cash overnight collateralized by Treasuries, has increased substantially this year.
On June 1, SOFR volume surpassed $1.6 trillion, the biggest since the New York Fed began publishing the rate in 2018.
“That data matches very well with the shorts by leveraged investors,” said Deutsche Bank’s Zeng. “This suggests that leveraged funds are going long in cash Treasuries and short in futures.”