A Mystery in 10-Year Treasuries Has Links to Carry Trade Blowup

Hedge funds are snapping up 10-year Treasury futures, and no other maturity, presenting a puzzle. The answer may lie in the collapse of a popular carry trade last year.

The highly-leveraged basis trade involved going long cash bonds and selling futures, to profit from the difference between the two, but came asunder in March 2020 when investors stampeded to buy the latter at the peak of coronavirus fears and upended the spread. Now the gap -- the so-called gross basis -- has reversed and favors shorting cash bonds and buying futures.

Of course, it’s not quite that simple. In futures markets, the counterparty who is short determines which specific cash bond traders have to deliver, adding another element of risk to the transaction. But with so-called ultra 10-year Treasury futures, there are only two bonds in the delivery pool, limiting that risk compared to other contracts.

That could be one reason why leveraged funds have built up net-long positions of almost 230,000 ultra 10-year futures, despite this year’s Treasury market slump, according to the latest data from the Commodity Futures Trading Commission.

A Mystery in 10-Year Treasuries Has Links to Carry Trade Blowup

As for the original strategy -- there are no signs of it returning anytime soon.

While returns from this year’s trade are much lighter, a play based on 10-year ultra futures is most attractive, according to one trader who asked not to be identified as he isn’t authorized to speak publicly.

Cash Bond Pressure

A sense of how the cheapest-to-deliver 10-year Treasury bond has performed against futures can be seen in the implied repurchase rate for the note. It flipped from positive to negative in the first quarter, indicative of greater selling pressure on cash bonds than futures.

“With the sudden and significant rates selloff in late February, Treasuries came under pressure, underperforming futures quite noticeably,” wrote Morgan Stanley’s Kelcie Gerson in a note this week. “On an outright level, futures/cheapest-to-deliver bases reached the widest levels seen since last March/April.”

A Mystery in 10-Year Treasuries Has Links to Carry Trade Blowup

Across the rest of the Treasuries curve, hedge funds hold net short positions, though well below last year’s levels after the collapse of the original basis trade.

A gauge of aggregate leveraged fund short futures positions -- which would likely be mirrored by long cash bonds in a basis trade -- has dropped by over $300 billion since last year’s February peak, according to calculations by Bloomberg.

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