Potential Hedge Fund Unwind Could Trigger Treasury Market Instability

Potential Hedge Fund Unwind Could Trigger Treasury Market Instability 

The interconnectedness of financial markets means that a potential deterioration in one area can create ripple effects across others. A weakening in credit markets, particularly marked by rising bankruptcy filings, could set off a chain reaction that forces hedge funds to unwind their positions in large bond futures trades. This unwinding process could contribute to volatility and a lack of liquidity in the Treasury market and potentially extend to other financial markets as well.

It is essential to understand that markets are deeply interconnected. This is evident when looking at the relationships between bond managers, hedge funds, and Treasury futures. Credit market conditions can serve as the catalyst for instability that affects not only the credit markets but also the Treasury market. Over time, these relationships have formed a complex network of dependencies, making markets more sensitive to disturbances, whether those disruptions come from bankruptcy filings or other shifts in market conditions.

This scenario also sheds light on why primary dealers find themselves holding large amounts of Treasury bonds. The current setup poses an ongoing risk to liquidity, which could disrupt not only the Treasury market but also broader funding markets.

Credit spreads, which have historically been a signal of economic conditions, are worth watching closely in such circumstances. Despite a weakening in the fundamentals of the economy and growing uncertainty, credit spreads have remained tight. Even as bankruptcy filings rise and volatility increases, these spreads have not widened, which would normally signal a slowdown in economic activity. The fact that spreads have stayed tight in the face of such uncertainty might be misleading, though, as their eventual widening could be a harbinger of broader economic slowdown.

Wider credit spreads would usually indicate that the economy is cooling off. However, in the current environment, they could mean much more than that. The interconnected nature of various markets suggests that a widening of credit spreads could set off a chain reaction, resulting in a divestment of Treasury bonds. This would place additional pressure on hedge funds to unwind their large futures positions, particularly if the expansion in credit spreads happens suddenly and sharply.

It's worth recalling the market disruptions seen in March 2020, when Treasury market liquidity dried up, and the Federal Reserve was forced to intervene. The events in that period provide a cautionary tale of what can happen when bond market imbalances cause liquidity issues. The unwind of large futures positions could have been one of the factors that led to that liquidity crisis.

An insightful observation following a recent discussion about Treasury market demand is that bond managers, who were once strong buyers of Treasuries, have been reducing their demand. Instead of purchasing Treasuries directly, these bond managers are turning to Treasury futures markets for duration exposure. A Treasury Borrowing Advisory Committee (TBAC) report from the previous year highlights this shift in strategy, noting that easier execution, the elimination of repo interest expenses, and more flexible leverage usage are some of the reasons behind this move.

A deeper analysis of the relationship between bond managers and hedge funds reveals some intriguing dynamics. Government bond issuance has caused the bond indexes tracked by bond funds to become increasingly weighted toward Treasuries, which has dampened the returns of those funds. This shift is also visible in the correlation between bond funds and high-yield debt, with the rising Treasury weighting in indices like the Bloomberg US Aggregate Index aligning bond funds' performance more closely with high-yield debt than before. However, this presents a mismatch in duration between the index, which has a duration of over six years, and high-yield debt, which has a much shorter duration of around three years. Bond managers typically prefer to match their duration with that of the index, and they have turned to Treasury futures to bridge this gap.

This growing reliance on futures has led to an interesting interaction between bond managers and hedge funds. In essence, hedge funds have been taking the short side of the futures positions held by bond managers, who are long on these futures contracts. The mechanism behind this is based on the fact that there is a persistent premium associated with buying bond futures. Asset managers are willing to pay this premium, and leveraged funds, such as hedge funds, are happy to harvest it by selling the futures contracts. The final step in this process is for funds to repo in bonds from dealers, borrowing the bonds to meet the short positions they have taken on the futures contracts.

The large-scale futures trading described above is not limited to just a few players; it has grown significantly in recent years. Research cited by the TBAC estimated that the size of the futures basis trade had reached $550 billion by the end of 2022. Since then, with hedge funds increasing their positions in bond futures by 50%, this figure could now exceed $800 billion. The size of this trade is noteworthy, as it recalls the events that led to the downfall of Long-Term Capital Management (LTCM) in 1998. In that case, the unwinding of large futures positions, combined with extreme leverage, led to a market crisis, which required a Federal Reserve-led bailout. While the leverage employed today by hedge funds in similar trades is lower than that used by LTCM, it remains a substantial risk.

Another important consequence of this growing reliance on futures contracts is the diminished liquidity in off-the-run Treasuries. Historically, asset managers would buy these less liquid bonds to meet their leverage and duration requirements, but with the shift toward futures, demand for these bonds has decreased. As a result, off-the-run Treasuries have become less liquid, particularly at longer maturities. This, in turn, has contributed to the accumulation of Treasury inventories by dealers, who are tasked with underwriting government bond auctions. When auctions fail to sell out, dealers are left holding unsold bonds, which they must hold on their balance sheets.

The larger issue here is that dealers' inventories, which have hit record highs, are now largely made up of off-the-run Treasuries. With a reduced demand for these bonds from both asset managers and banks, dealers are finding it increasingly difficult to unload them. This creates a potential source of instability in the market, as dealers struggle to find buyers for these bonds. A lack of demand, combined with constrained dealer balance sheets, can amplify market volatility.

The consequences of this situation could also spill over into broader financial markets. Over the past year, we've seen the cost of equity funding provided by dealers increase substantially, making it more expensive for investors to take long positions in the market. Similarly, the cost of using dealers' balance sheets to add leverage has been rising steadily throughout the past year. These rising costs of funding can exacerbate the stress in the market, further increasing the risk of instability.

While it is possible that credit markets remain strong and do not spread weakness to the Treasury market or beyond, the risks associated with the current market dynamics are significant. The interlinked nature of these markets means that a disruption in one area can quickly lead to broader consequences. Financial markets, like nature, are resistant to vacuums, and the current imbalances suggest that any instability in credit or bond markets could have far-reaching effects. It is, therefore, essential for market participants and policymakers to remain vigilant about these risks and their potential impact on market stability.