The basis trade and repo rates
Connecting the dots on Treasury futures
The cash–futures basis trade is on everyone’s short list for “What could unravel in 2024?” Hedge funds’ short positions in Treasury futures have contracted only modestly from their $800 billion fourth-quarter peak (negative values indicate net short positions):
The same CFTC data shows that asset managers are taking the corresponding long positions:
Why? Over the last two years, rates have been rising, meaning that bond prices have been falling. Asset managers, sensitive to these falling prices, enter long futures contracts on Treasuries to shorten the durations of their portfolios, so reducing their exposure to interest-rate risk. These purchases drive futures prices up relative to spot prices, or in other words they cause the cash–futures basis to increase.
Hedge funds see this widening basis and enter the offsetting short positions in Treasury futures, borrowing the funds from their dealers using repo. Dealers in turn borrow from money market funds, also using repo. A recent piece in the BIS Quarterly Review, by my co-author Iñaki Aldasoro and his colleague at the BIS Sebastian Doerr, notes that dealers are using the DTCC’s sponsored repo service for these trades, to minimize the amount of capital they need to post.
Intriguingly, repo rates on the FICC’s DVP and GCF repo services have spiked relative to other overnight rates, pulling the benchmark SOFR average up with them:
Hedge funds have to pay those rates in order to stay in the Treasury basis trade. If they stay high, expect the basis trade to unwind more quickly.
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Previously on Soon Parted
Stablecoins paper PDF: https://www.bis.org/publ/work1146.htm