By Jamie McGeever
ORLANDO, Fla. (Reuters) – Investor positioning in U.S. Treasury futures is reaching extreme, and in some cases record, levels that are likely to rekindle concerns about potential liquidity and stability risks in the world’s largest and most systemically important bond market.
The increase in “long” positions by asset managers and “short” positions by leveraged funds suggests that the Fed will soon begin a rate-cutting cycle as inflation slows and economic activity cools.
It is unclear whether these moves were the result of so-called “basis trading,” where leveraged hedge funds trade the small price difference between cash Treasuries and futures, using the money to fund the repo market that day.
Funds are essentially selling Treasury futures, and asset managers are the buyers. Financial authorities and regulators have warned that these funds, some of which are leveraged up to 70 times, pose a financial stability risk if they have to quickly liquidate their positions.
But what is becoming increasingly clear is that the U.S. bond market is at a turning point in terms of Federal Reserve policy, and the long-term fiscal outlook remains very challenging, to say the least.
The possibility of price shocks or policy mistakes cannot be ignored. For example, what if the Fed cuts rates by 50 basis points instead of the 25 basis points expected in September due to a sharp deterioration in economic or labor market data?
This comes against the backdrop of recent Commodity Futures Trading Commission figures showing that asset managers and leveraged funds’ positions, particularly at the front end of the yield curve, are at or near record highs.
According to CFTC data, asset managers’ total long positions in two-, five- and 10-year futures reached a record $1.083 trillion in the week through July 9, up about 30% since March.
Total short positions in leveraged funds now stand at $1 trillion, up about 25% from March and approaching the record high of $1.1 trillion set in November last year.
Among them, asset manager long positions and leveraged fund short positions in 5-year maturities hit record highs of $373 billion and $321 billion, respectively, while asset manager long positions in 2-year futures hit a record high of $477 billion in the week of July 2.
A long position is a bet that the value of an asset will rise, while a short position is a bet that the price of an asset will fall.
Works smoothly
Positions across the curve are at record levels, adjusting the time frame and softening the overall market’s sensitivity to movements in Treasury yields, according to Matt King, founder of financial market research and consulting firm Satori Insights.
As long as these offsetting positions can be matched when one side decides to cut, the market will continue to function smoothly. Historically, market-making broker-dealers filled all the gaps, but that role is now being filled by clearing houses.
The larger the position, the bigger the potential hole due to a quick reversal. Regulators do not want a repeat of March 2020, when hedge funds unwound their short positions in a disorderly manner, causing severe volatility and liquidity shortages in Treasury markets.
Matt King of Satori Insights says it’s not immediately apparent. He points out that a healthy, liquid market actually needs to have a diverse investor base that encompasses hedge funds and “real money,” long-term and short-term, value-oriented and momentum-oriented players.
However, it is worth watching the size of the cumulative positions.
“You might think that this is putting pressure on the pipes, but if everything is centrally managed and properly margined – without having to go through dealer balance sheets – then it should be possible to handle that volume,” King said.
“I would be concerned if we really dug into the weeds of the settlement process and concluded that the pipes couldn’t handle the load, but I’m not prepared to make that conclusion at this point,” he added.
(The opinions expressed here are those of the author and Reuters columnist.)
(by Jamie McGeever)
