Heresy Financial: Hedge Funds Have Put the Entire Treasury Market at Risk of Collapse

Investor returns in 2023 have shifted largely due to moves in the U.S. Treasury market. As the 10-year U.S. Treasury bond yield neared 5 percent in the fall, stocks saw a big selloff. And as yields on that bond came down, markets rallied.

Currently, hedge funds are building their largest position ever shorting Treasury bonds. That’s not due to any expected big shift in yields. Rather, it’s from using a leveraged strategy to make small, consistent profits.

The trade is known as a basis trade. It seeks to make profits from small changes in the relative value between bonds. That means funds are using arbitrage – simultaneously going long on one bond while shorting another.

And hedge funds can use leverage to borrow as much as $50 for every $1 invested.

If these trades go wrong – and given the bond market volatility this year it’s possible – hedge funds can get wiped out. To face their margin calls on a bad trade, they would have to sell off assets that have been performing well.

That could lead to a cascade of sell orders hitting other bonds, stocks, real estate, and so on.

Even if a fund isn’t wiped out from being on the wrong side of a trade, these trades can increase volatility in the treasury market. That means investors looking for the safety of bonds may get whipsawed.