The Big Read US Treasury bonds
How the Treasury market got hooked
on hedge fund leverage
Recent turbulence was partly the result of trading
strategies using derivatives. But the same investors are
increasingly important buyers of US government debt
By Robin Wigglesworth, Kate Duguid, Costas Mourselas and Ian Smith
Published 9 HOURS AGO
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Over the past few weeks, the bond market has done what many of Donald Trump’s opponents have
failed to do. It has forced the American president into a partial retreat on tariffs, after a rout in US
government debt threatened to spill over into a financial calamity.
Analysts and fund managers say the Treasury sell-off was primarily powered by a retrenchment of
investors from the US government bond market, fearful that tariffs would fuel inflation and
unnerved by what some say is an increasingly erratic administration that has antagonised allies
and imperilled the country’s own economy.
However, many stress that the turmoil was also exacerbated by highly leveraged hedge fund
strategies. These “relative-value” trades usually seek to take advantage of often tiny differences in
prices between Treasury bonds and various derivatives contracts linked to them. Using short-term
funding markets to borrow extreme amounts of money, they can transform small profits into large
ones.
These trades have helped turn the club of big hedge funds that pursue them into vital pillars of the
$29tn Treasury market, helping restrain the US government’s borrowing costs at a time when
interest rates have been rising. Their importance is only likely to climb if foreign investors pull
back from the Treasury market, as many analysts and fund managers predict.
However, many fear that they also make Treasuries vulnerable to sudden shocks. Even the Federal
Reserve has argued that the growth of these leveraged hedge fund strategies — such as so-called
“basis trades” or “swap spread trades” — is a risky development for a market that funds the US
government, historically acts as a safe shelter for global finance and influences the pricing of
virtually every other security on the planet.
Treasuries were rattled by an unwind of these trades in the financial maelstrom triggered by Covid19 in March 2020. However, that shock was easier to dismiss as an aberration because of the
unique nature and scale of the pandemic. The renewed hints of fragility have therefore alarmed
many analysts and investors, and exacerbated simmering concerns over the health of the world’s
most important market.
“There are still vulnerabilities in our financial system, up to and including our sovereign debt
markets,” says Richard Berner, a finance professor at NYU and the first director of the US
Treasury’s Office of Financial Research, set up after the 2008 crisis to study systemic risks. “These
vulnerabilities are typically exposed by shocks — and we just had another big one.”
In June 1979, a desperate broker called John F Eckstein III approached Salomon Brothers with a
proposal. “I got a great trade, but I can’t stay in it,” Eckstein pleaded with the assembled Salomon
traders, according to Roger Lowenstein’s When Genius Failed. “How about buying me out?”
Eckstein was the head of a small brokerage firm called JF Eckstein & Co, which specialised in a
then novel area: financial futures, derivatives contracts tied to the price and delivery of securities
rather than commodities such as oil or orange juice.
Back in 1979 these had only been around for a few years, and Eckstein had noticed a curious glitch:
their novelty meant that Treasury futures were far cheaper than the Treasuries that you had to
hand over on the contract’s maturity. Eckstein could therefore buy the futures, bet against the
bonds, and pocket a near risk-free return as the “basis” — the term for the price difference between
a financial security and its derivative — between the two inevitably converged. After all, the
Treasury future in effect became a Treasury bill on its maturity. Moreover, because the securities
involved were so safe, he could also borrow lots of money to build big positions.
Hedge funds have continued to build large derivatives positions in
Treasuries
By short futures contract ($bn)
Two-year
Five-year
10-year
Ultra 10-year
30-year
Ultra 30-year
Covid-19
rattles
market
1000
500
0
2015
2016
2017
2018
2019
2020
2021
2022
2023
2024
2025
Sources: OFR, CFTC
The problem, as Eckstein discovered to his chagrin that summer, was that his counterparties would
demand more collateral if prices diverged rather than converged — even if it was just temporary.
Unable to stump up the cash, he was forced to ask Salomon to take the trade off his hands, or risk
JF Eckstein & Co going under. Fortunately, a young star Salomon trader called John Meriwether
seized the opportunity. It proved a bumpy ride, but made Salomon millions and Meriwether was
soon afterwards named a partner.
When Meriwether set up his own hedge fund in 1994 — the now infamous Long Term Capital
Management — he industrialised this Treasury “basis trade”. But by then the strategy had morphed
into something closer to its modern-day incarnation.
Over time, investors became more comfortable with interest rate derivatives, and eventually grew
to love them. With futures, an investor initially only needs to put down some of the contract’s
nominal value. The cash they save can then be gainfully deployed elsewhere in the meantime.
As a result, the contracts nowadays typically trade at a premium to the Treasuries that are
delivered on their maturity, rather than the discount that Eckstein had noticed decades ago. The
modern day basis trade is therefore to buy Treasuries and sell Treasury futures.
The quality of US government debt means that they can use the bonds purchased as collateral for
loans in the short-term “repo” money market, obtaining as much as 100 times leverage — in other
words, only putting down $10mn of capital to support a $1bn trade. This can turn a few measly
basis points of returns into steady and healthy profits.
John Meriwether, who made a name for himself at Salomon Brothers, industrialised the Treasury ‘basis trade’ after he set up his own firm, Long Term
Capital Management, in the 1990s © James Leynse/Corbis/Getty Images
According to the Securities and Exchange Commission’s latest data, there is about $904bn in
hedge funds that engage in fixed-income relative-value trades in government debt, almost doubled
from a decade ago.
One top hedge fund manager estimates that Treasury basis trades generate roughly $8bn in
aggregate revenues a year, most of which accrues to the dozen or so firms that dominate it. These
range from large funds like Citadel and Millennium to more specialist firms such as Symmetry
Investments and Alphadyne. “I don’t particularly like the basis trade, but we do it because it
exists,” he says. “It’s basically providing a service.”
However, as Eckstein discovered in 1979 — and Meriwether’s LTCM in 1998 — counterparties
often demand more collateral when the Treasury market is unusually turbulent. If a hedge fund is
unable to pony up when these “margin calls” are made, they have to either unwind the trade
themselves or have it forcibly unravel as lenders seize the underlying collateral.
This is what happened in March 2020. Postmortems conducted by the likes of the Bank for
International Settlements concluded that turmoil in Treasuries that month was started by foreign
central banks selling to raise dollars and support their domestic economies, and then exacerbated
by bond mutual funds ditching the only securities they were still able to get a decent price for — US
government debt.
This “dash for cash” then nearly escalated into a financial crisis, when hedge fund basis trades were
ripped apart by the ensuing volatility. Only the Fed buying hundreds of billions of dollars’ worth of
Treasuries averted a cataclysm.
Investment bank trading desks and hedge fund managers say there was a repeat of this dynamic in
April, with Treasury basis trades unwound rapidly as the turbulence began to grow after a weak US
government debt auction on April 8.
But it remains unclear exactly how big a contributor the basis trade was to the overall severity of
the Treasury rout. Analysts and fund managers say the prices of Treasury futures and the “cheapest
to deliver” bonds that can be handed over at the contract’s maturity suggest the unwind was
orderly this time, unlike the chaotic liquidations of March 2020.
“A close examination of Treasury futures bases show little signs of stress, and suggest that this is
one corner of the broader market that is weathering the crisis very well so far,” JPMorgan’s bond
analysts wrote in a report.
Nonetheless, the scale of the Treasury basis trade — hedge funds were net short $1.14tn of Treasury
futures in mid-March, according to the OFR, and estimates of the aggregate size of the basis trade
itself are generally around the $800bn mark — still meant that even a controlled retrenchment had
a sizeable impact on the market, according to Gregory Peters, co-chief investment officer of PGIM
Fixed Income.
“These trades are quite sizeable,” he says. “Things might have been orderly, but these were big, big
moves.”
Moreover, basis trades are just one of myriad bets that fall under “relative-value” hedge fund
strategies in fixed income. For example, the retrenchment of trades that take advantage of subtle
price differences between newly issued Treasuries and older “off-the-run” ones has probably also
contributed to the turbulence, analysts say.
But most argue that the biggest driver was a violent unravelling of bets on so-called “swap
spreads”.
Tighter regulations after the financial crisis of 2008 have constrained the ability of banks to hold
lots of financial securities on their balance sheet, even US Treasuries. This has led to an odd
phenomenon. For most of the past decade, the yield of the fixed leg of an “interest rate swap” —
derivatives that allow investors to exchange fixed and floating interest rates — has been
significantly lower than that of comparable government bonds. In financial parlance, swap spreads
have been negative.
However, expectations that the Trump administration would roll back regulations led to
investment funds wagering that swap spreads would normalise — betting against interest rate
swaps and buying Treasuries as a hedge. As with the Treasury basis trade, the solidity of the
underlying securities meant that they could use big dollops of leverage to juice the returns.
But when the Treasury market’s volatility suddenly surged after Trump’s “liberation day”, the
trades came undone in dramatic fashion, instead sending the spread between Treasuries and swaps
spiralling into even deeper negative territory.
“It was a tough dynamic,” says Robert Dishner, senior portfolio manager at Neuberger Berman,
saying the sell-off had parallels to the bond market turmoil that followed UK Prime Minister Liz
Truss’s ill-fated 2022 “mini” Budget and LTCM’s collapse in 1998. Finn Nobay, a trader at
investment firm Payden & Rygel, calls it a “self-fulfilling pain trade”.
The cumulative effect of these leveraged trades being unwound was severe, albeit not as extreme as
it was when Covid hit markets in 2020.
The liquidity of the US government bond market — as measured by the rolling sum of the best
three offers to buy and sell Treasuries — is a good proxy for the overall severity of the turmoil. This
fell to a low of just $67mn in mid-April, according to JPMorgan, down from a previous range of
about $200mn-$300mn, but comfortably higher than the $38mn nadir during Covid.
Not that this has assuaged the growing concerns. “That we’re seeing these extreme moves in US
rates should be much more unsettling to the investor community than it has been,” argues Peters.
“Is the Treasury market functioning? Absolutely. It’s not like 2020. But it’s still very fragile.”
Rightly or wrongly, some mysterious investment strategy often emerges as a convenient
scapegoat whenever financial markets are turbulent. Moreover, the psychological scars of 2008
have meant that many are primed to constantly worry about similar debacles.
“People are always looking for the next financial crisis,” observes Bill Dudley, the former head of
the New York Federal Reserve. He argues that Treasury yields primarily climbed higher because
the Trump administration’s haphazard approach meant investors had to price in a wider range of
outcomes into the market. “There doesn’t seem to be much evidence of serious dysfunction in the
Treasury market,” he says.
A group waits to enter the New York Stock Exchange. It is not yet clear exactly how big a contributor the basis trade was to the severity of the Treasury
market rout © Adam Gray/Getty Images
Nevertheless, whether the main culprit was basis or swap spread trades this time — or perhaps
some other variant of Treasury market arbitrage the next time — the overall takeaway should be
that highly leveraged hedge fund trades that rely on fickle short-term funding markets make the
systemically important US government debt market more fragile, according to NYU’s Berner.
“These trades provide liquidity in calm times, but disrupt it in tumultuous times,” he says.
Regulators are not blind to the dangers. There were concerted efforts to ameliorate the risks in the
wake of the Covid outbreak, led primarily by Gary Gensler during his period as head of the US
Securities and Exchange Commission.
In 2023, the SEC passed a “central clearing” rule, which would have restructured the Treasury
market’s plumbing by mandating that more trades should be done through a clearing house. That
model — in which a third party guarantees every deal in the Treasury market — would have forced
hedge funds to hold far more cash, reducing the overall amount of leverage in the system. In 2024,
the SEC also passed a so-called dealer rule, which would have forced hedge funds to register as
broker-dealers and subjected them to greater regulatory oversight.
However, hedge funds have pushed back on these rules — and mostly won. The dealer rule was
thrown out in a federal court in Texas in 2024, and Trump’s SEC has withdrawn its legal challenge
to that decision. The central clearing rule still stands and was expected to be implemented by 2026,
but Wall Street has asked the SEC to extend the timeline for adoption.
Even some of the hedge fund managers that engage
In a world where people
can’t put on those
trades . . . Treasury yields
would be much higher and
US taxpayers would pay far
more to borrow money
in these highly leveraged relative-value trades
acknowledge that without stricter regulatory
guardrails, the possibility of more violent episodes of
Treasury turbulence is high. “For sure it makes it
more unstable, 100 per cent. But the issue is the
Treasury market is unstable,” says one. “It’s unstable
because there is a lot of supply [of US government
debt].”
Indeed, the conundrum confronting those regulators
and policymakers that might still want to neuter these strategies is that the Treasury market has
come to depend upon them.
The gross US government bond holdings of all hedge funds that report to the SEC stood at nearly
$3.4tn at the end of 2024, and has roughly doubled just since the beginning of 2023, according to
the OFR. Much of this will be held through myriad other strategies, but judging by the size of the
short Treasury futures positions, most estimates are that fixed-income relative-value hedge funds
in aggregate probably hold roughly $1tn of Treasuries.
That would mean that these strategies now hold almost as much US government debt as Japan’s
central bank, the single biggest overseas holder, and more than China’s official holdings. With
foreign investors already nervous about the Trump administration, it means the health of the
Treasury market might be hostage to the very same trades that occasionally cause it palpitations.
A senior executive at one of the world’s largest trading firms concedes that the growing presence of
hedge funds and trading firms in the Treasury market would inescapably make it more volatile.
This in turn could lead to investors demanding higher yields as compensation. However, given the
scale of US government debt issuance, their involvement is necessary.
“In a world where people can’t put on those trades . . . Treasury yields would be much higher and
US taxpayers would pay far more to borrow money,” he says.
Peters agrees that “there’s a tremendous amount of debt that needs to be absorbed”. He adds: “If
that [hedge fund purchases] goes away, then I really worry about what the clearing level of
Treasuries would be.”
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