The most crowded trade in fixed income appears to be running out of room. Hedge funds that have piled into the Treasury bond basis trade, a leveraged strategy that has quietly become one of Wall Street’s favorite money machines, are finding that the party might be winding down.
Morgan Stanley estimates that leveraged positions in the trade have declined by more than $200 billion, bringing the total down to roughly $1 trillion.
What the basis trade actually is
Here’s the setup. Hedge funds buy actual Treasury bonds in the cash market while simultaneously shorting Treasury futures contracts. The goal is to capture the tiny price gap between the two. The spread between cash bonds and futures is usually razor-thin. We’re talking basis points. So to make the math work, funds crank up leverage, sometimes 50x or more, turning a whisper of profit into a shout.
Eli Carter, a US rates strategist at Morgan Stanley, pointed to the stagnation in expansion as evidence that the strategy may have reached its maximum capacity.
