Central bank body warns hedge fund bets risk dislocating US Treasury market

investmentweek.co.uk:

According to the BIS, leveraged funds have built up net short positions in US Treasury future of around $600m in recent months.

In its quarterly review report published today (18 September), the umbrella group for central banks issued a warning about the growth of ‘basis trade', a hedge fund strategy in which investors attempt to profit from small price discrepancies between Treasury bonds and their futures market equivalents.

According to the BIS, leveraged funds have built up net short positions in US Treasury futures of around $600m in recent months, with more than 40% of the net shorts concentrated in two-year contracts. 

These funds had been at comparable level of net shorts in the run-up to the repo market stress of September 2019, as well as the US Treasury market dislocations of March 2020, which ultimately forced the Federal Reserve to step in.

Global financial watchdog issues stark warning over further shocks — reports

«Given these experiences, the current build-up of leveraged short positions in US Treasury futures is a financial vulnerability worth monitoring because of the margin spirals it could potentially trigger,» the BIS wrote. 

«Margin deleveraging, if disorderly, has the potential to dislocate core fixed income markets.»

The BIS explained that when Treasury futures are priced at a premium relative to cash bonds, a common relative value trading strategy consists of selling futures forward, or building short positions in futures, matched by long positions of bonds in the cash market. 

«Such a trade generates profits because the futures and cash prices eventually converge on the futures contract's expiration date,» it said. 

«Since the basis is typically narrow, investors need to boost profits through